Accrual vs cash accounting for tax purposes

Accounting has two methods: Accrual vs cash accounting. Both have a different effect on taxes and business. Before learning more about accounting method, please consider following facts about choosing and implementing accounting method in your business:

 

1. It is wise to choose accounting method before filing your first tax return.
2. You can choose a different accounting method for your business and personal items. You may account your personal items on a cash basis and business items on an accrual basis.
3. If you have two separate business, you can choose different methods for both businesses. You should maintain separate books of accounts for both businesses. There should not be the intention of tax evasion in implementing different accounting methods.

 

Cash accounting method:

Cash accounting is useful for small business owners or when most of the transactions on a cash basis. Transactions are recorded when there is cash movement in business.

Individuals and small business owners choose this method of accounting. You are only required to keep an eye on cash movement. So it is quite simple.

 

Who can choose cash accounting method?

Not every business is allowed to maintain an account on cash basis. Following entities cannot choose cash accounting:

1. Corporation ( other than s corp) having average annual gross receipts exceeding $5 million dollars.
2. A partnership with a corporation, having average annual gross receipts exceeding $5 million dollars.
3. Tax shelter
4. You do not produce, purchase or sell merchandise and not required to keep inventory.

 

How to calculate gross receipt?

 

Gross receipt can be computed with following formula:

 

(Gross receipt of tax year + Gross receipt of previous two years ) / 3

Shift to accrual accounting:

When any business fails above test and its turnover exceeds the limit, the business should adopt the accrual accounting from the tax year when it fails the test.

Now, Let’s understand accounting using the cash method.

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Cash Receipts:

You should record cash receipts as income. Cash receipt includes actual receipts and constructive receipts. Cash receipts when you receive money in your hand. Constructive receipts mean amount credited to your bank account or available for you without restriction. IRS suggests you should include constructive receipt and actual receipts while filing your taxes.

 

Cash Expenses:

You can claim expense paid via cash or bank as deductions. However, expense paid in advance cannot be deducted in the current year. The amount should be capitalised. However, you can use 12-month rule in certain cases.

 

Expense paid in advance and 12 month rule:

 

You are required to follow 12-month rule when you pay some expense in advance and benefit of expense does not extend beyond the earlier of following:

1. 12 month from the date of benefit begins
2. Last date of the tax year after the tax year when payment is made.

As per 12 month rule, you can deduct 100% amount in the year of payment of expense.

 

Example:

1. Alex pays $15000 as advertising expense on 28 February 2016. His tax year is the calendar year. The benefit of advertising extends up to 31 January 2017. In above case, Alex can claim $15000 as an expense as 12-month rule applies.
2. In above case, if benefit extends up to 30 April 2017, Alex can claim $12000 as an advertising expense for 2016 and $3000 for 2017 tax year.

 

Accrual accounting:

Accrual accounting is the most reliable method of accounting. It shows you the true picture of profitability of business. Under accrual accounting, income is reported when it is earned and related expense should be deducted from the income. There are certain rules under US taxes about accrual method.

Let’s understand how to treat transactions as per US laws using accrual accounting.

 

Treatment of income:

In this method, transactions have been recorded on the earliest  of the following:

1. when payment is received by you.
2. When invoice is due
3. When title passes
4. When you earn the income.

When you cannot decide income accurately, you can report estimated income and difference in estimation can be reported in next year.

 

Treatment of advance received for services:

You should treat an advance as income in the year you receive the payment. However, using deferral rule, you can report this income in next tax year.

 

Advance received for sales:

The advance should be treated as income. However, you can choose an alternative method of reporting:

 

Alternative reporting method:

You should include advance payment in the earlier tax year

1. The year when you report advance as income while preparing accounts for tax purpose
2. The Year when you report advance as income while preparing accounts for financial reporting.

There is some exception to above rule for inventory goods.

 

Please note that you should attach following statements while following alternative reporting method:

1. Total advance received
2. Total advance received in earlier tax years and not reported before current tax year.
3. Total advance received in earlier tax years included in income for the current tax year.

 

Example:

Ben is following calendar year as tax year.Ben is following accrual accounting method.  Following transactions are recorded during December month.

 

1. Ben sold $1200 goods to Ken on credit basis on 1st December 2016. Ben has received the due on 1st February 2017.
2. Ben sold $1500 goods to Alex on 22nd December 2016 and received $1500 on the same day.
3. Ben has received $2200 advance for future sale on 21st December 2016.

 

Accrual Accounting:

 

1. In accrual accounting, the transaction is important. There is valid sale transaction in December month. It does not matter whether he receives money or not. So he should record $1200 sale in December month.
2. He should record sale $1500 in December.
3. Ben should record $2200 as income in the tax year, 2016.

 

Expenses:

 

There are two options to treat expense as per accrual accounting:

1. Deduct in current year
2. Capitalize it and deduct in future tax year/ years.

The expense should pass all-events test and economic performance should have occurred.

 

Let’s understand how we should treat various expense following US tax laws.

 

1. Workers’ Compensation should be deducted when payment has been made.
2. Taxes should be deducted when paid. However, you can treat taxes as recurring items and deduct estimated taxes for the year.
3. Interest should be deducted in the year of payment.
4. Wages/salaries to employees can be deducted in the year when employees render services to the company.
5. Vacation pay can be deducted in the same year when an employee takes a vacation. You should pay this amount not later than 2.5 months after the end of the tax year.
6. Other liabilities such as the penalty for violation of laws, refunds, rebates, the warranty should be deducted in the year of payment.

 

The concept of recurring items:

 

Using this concept, you are allowed to treat certain items incurred in tax year though economic performance has not occurred. The following conditions should be met to use this exception:

1. The all events test is met.
2. Items are not material or using recurring item concept, the expense match revenue in a better way following GAAP principle.
3. The items are recurring in nature and you follow all events test for these items.
4. Economic performance occurs by earlier of the following: the date of return filing or 8.5 months after the close of the tax year.

 

Examples of recurring items:

1. Stationary purchase
2. Monthly subscription
3. Telephone expenses

 

Expenses paid in advance:

Expense paid in advance should be deducted in the year to which it applies. You can use 12-month rule for advance paid. 12-month rule has been discussed earlier in this article.

 

Inventory management:

You are required to follow accrual accounting method when you are required to account for inventory. You can account inventory using GAAP principles and IRS rules for valuing inventory.

We understand how both accounting method work. Let’s understand pro and cons of cash and accrual accounting.

 

Accrual vs Cash accounting – Advantages and disadvantages

 

Cash Accounting: 

Advantage:

Easy to understand: Cash accounting is really very easy to understand. No accounting background is necessary to record the transaction. There is less chance of error as you are only giving effect as per cash movement.

Easy to implement: As mentioned before, you are not required to hire an accountant to implement accurate accounting. You can do your own accounting without learning A-B-C of accounting principles.

Best fit for tiny business:

When turnover is very small and most of the transactions are in cash, this method is suitable. However, with the growth of the business, one day you need to move from cash to accrual accounting and switching may be a headache.

 

Disadvantage:

1. Inaccurate Reporting: The biggest disadvantage of cash accounting is wrong reporting of business. Your profit and loss account does not show the real profit. Which affects your business decision.
2. switching from cash to accrual accounting: You need to follow the long procedure to switch from cash to accrual accounting. If you have already adopted any accounting method and filed your tax return, you are required to get IRS permission before switching accounting method.

 

Accrual Accounting:

 

Advantage:

1. Used by most of the businesses: Accrual accounting is being used by most of the businesses. So it is wise to follow the same policy in your business.
2. Comparision: You can compare your financial results with other companies as the method of accounting is same.
3. Reliable: You can rely on the report prepared as per accrual accounting. Accrual accounting shows a true profit for any given period of time. It also shows true position of business via balance sheet.
4. No need to switch: The other benefit of accrual accounting is no worries to switch from cash accounting to accrual accounting. Your accounting base is already strong if you start using accrual accounting from the first day of business.

 

Disadvantage:

1. Difficult to understand: There are many accounting terms and treatment you need to understand to use accrual accounting. You are required to follow all principles of accrual accounting to get the true result of business. If you miss one rule, there might be the wrong number with you.
2. Costly: You should hire the qualified or semi qualified person to manage your accounts. Doing billing entries is an easy task but putting all numbers together and producing accurate result requires skill.

 

Switching from cash to accrual method or vice versa:

 

You can switch your accounting method before filing the first return without IRS approval. However, you need to get IRS approval afterwards. You are required to file form 3115 for it.

 

Changing accounting method is not easy. You are required to fulfil all the conditions for it. That’s why it is wise to choose best accounting method from the beginning of the business. Which accounting method do you follow? Share your experience about it via comment box.