You have probably heard about the “method” of accounting before (also referred to as the “basis” of accounting). But what does that mean to you? Your method, or basis, of accounting determines how things are recorded (or recognized) and realized on the financial statements. To be honest, in the lifetime of a business, the methods used will equal out. However, in interim years of a business’ life cycle, the method of accounting can have a major impact into the amount of income (or loss) for that specific year.
Understanding the methods of accounting, as well as knowing what method your business follows, can enable better tax planning. This also means less surprises on tax day. (No one wants the shock of owing $17,000 on April 14th, when all along they thought their business had a loss for the year!)
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Cash Method of Accounting
The first method is the cash method of accounting. Under the cash method of accounting, revenues are not recognized as income until the payment is received. This may be weeks or longer after the job has been performed. Expenses are also not recognized until payment is made. Payment may be either a check written, or a credit card charge incurred.
The cash method of accounting is straightforward. There is also room for flexibility, especially on the expense side. If it is more beneficial to incur an expense 20X1, as opposed to 20X2, the check just needs to be written in 20X1. However, if it is more beneficial for an expense to be incurred in 20X2 instead, you may hold off on writing the check until January 1, 20X2.
Under the cash method, timing is everything! If you don’t receive payment from your customer until January 2, that income doesn’t get reported to the government (aka taxed) until the following year. This can be a good thing - who doesn’t like keeping money in their pockets for longer?
Accrual Method of Accounting
The second method is the accrual method of accounting. The accrual method is used for GAAP (Generally Accepted Accounting Principles). Under the accrual method, revenues are recognized as income when the job is done (even if payment is not received at that time). Expenses are recognized when the expenditure is incurred (even if payment is not made at that time).
The accrual method is a more realistic picture of the business’ operations, given that it includes all known and expected revenues and expenses, not just those that have had cash receipts or payments made. However, there is also less flexibility with timing of recognition. You aren’t relying on the mailman to determine when your income is recognized.
Tax Planning - Know Your Method
For many businesses, it is most effective to follow the accrual method of accounting to run their business. It is helpful to know what vendor payments (accounts payable) are coming due, and it is vital to know what customer receipts (accounts receivable) are upcoming.
However, many small businesses may qualify for the cash method for their income tax returns. Starting in 2018, the threshold to require the accrual method for income tax purposes is gross receipts of $25 million. This means more small businesses can opt to use the cash method of accounting for their income tax returns.
This is generally good news due to the flexibility with planning. Many accounting software options, including QuickBooks, allow the dual use of methods. So, financial statements can be run on both the cash and accrual methods at the push of a button. However, it is important to keep in mind that net income can fluctuate quite a bit between the two methods. So even if you showed a loss on the accrual method, you may have taxable income on the cash method, and vice versa.
As you prepare for taxes, be aware of the potential large differences. I have witnessed business owners that were shocked at tax time because of these major swings of which they were unaware. Also be aware that QuickBooks and some other software products may have issues if you have entered any journal entry transactions that impact Accounts Receivable or Accounts Payable.
A Tale of Two Methods, or Is It?
Keep in mind that over the business’s entire life cycle, these timing differences in recognition will be eliminated between the cash and accrual methods. For example, if you delay recognition of a customer payment on the cash method, due to not receiving it until January, you will pick up that income on next year’s return. In the grand scheme of things, the business would recognize the same total amount of income (just over different years). The same is true for expenses.
Knowledge is the first step to action. Now that you understand the tale of two methods of accounting, take action. Check out what method you use for your tax return (it should be shown on the tax return). Let me know if I can help at all with understanding your basis of accounting. You will then be in a good position to take action with your year-end planning.