Cash Basis versus Accrual Basis Accounting
There are basically two accounting methods for managing your contracting or service company’s books. These accounting methods include “cash accounting” and “accrual accounting”. In this article, I want to discuss both of these and explain which is most appropriate for you and why.
Please understand that these methods apply to bookkeeping and tax return preparation differently. There will be more on that later in this article.
Under The Cash Basis of Accounting
- Revenues are reported on the income statement in the period in which the cash is received from customers, deposited, and cleared the bank account.
- Cost of Goods Sold (Expenses) are reported on the income statement when the cash is paid out and that payment clears the bank account.
- Payroll expenses are recognized when the payroll check is cashed and the clears the bank account.
- Revenues are reported on the income statement when they are earned; which often occurs before the cash is received from the customers.
- Expenses are reported on the income statement in the period when they occur or when they expire; which is often in a period different from when the payment is made.
Under the Accrual Basis of Accounting
The accrual basis of accounting provides a better picture of a company’s profits during an accounting period. The reason is that the income statement prepared under the accrual basis will report all of the revenues actually earned during the period and all of the expenses incurred in order to earn the revenues.
The accrual basis of accounting also provides a better picture of a company’s financial position at a moment or point in time. The reason is that all assets that were earned are reported and all liabilities that were incurred will be reported.
The accrual basis of accounting forces something accounts call “the matching principle”. This basically means that revenues are tied to the corresponding (matching) cost of goods sold and labor expenses. It also matches revenues and expenses together in the same period in which they occur. In fact, job costing is NOT possible under the cash basis of accounting.
Cash Accounting in the Real Word
Imagine buying $50,000 worth of materials for a job that starts next month. Your income statement would show a $50,000 loss for that month. Next month you do the work and get paid $100,000. That month you would show $100,000 in income with no cost of goods sold. That’s cash accounting and that’s no way to manage a business.
When to us Cash Accounting
I really don’t want to see anyone use cash accounting. However, if you are a one or two person company with few liabilities and no inventory, it might be okay.
Accrual Accounting in the Real Word
Imagine buying $50,000 worth of materials for a job that starts next month. Your balance sheet would show a $50,000 asset called inventory. Your income statement would not change. Next month you do the work and get paid $100,000. That month you would show $100,000 in income and $50,000 in cost of goods sold. Your balance sheet would show zero inventory. That’s accrual accounting and that’s how you run a business.
Financial management through cash basis accounting is dangerous. Cash accounting creates useless financial reports such as a job costing reports, balance sheets and income statements. That is because revenue is only recognized when you make a bank deposit. Expenses are only recognized when the check clears the bank. Labor expenses are only recognized when your employee cashes their payroll check and that check clears the bank. Accrual accounting allows you to monitor the profitability of your jobs. It creates useful reports that allow you to make import business decisions.
Accrual Accounting and Your Tax Return
You can manage your business with accrual accounting and still file your taxes under the cash basis. Your accountant can easily adjust your balance sheet and income statement for that purpose using nothing more than a pencil and a calculator. The process takes just minutes and basically goes like this.
Income is reduced by Accounts Receivables. Cost of Goods Sold (COGS) is reduced by the amount of your Accounts Payable. Costs of Goods Sold is increased or decreased by changes in your inventory value.
So basically, income (sales) will be reduced by the amount that you have not collected on. Expenses will be reduced by the amount that you have not yet paid.
Accounting Method Selection and Your Tax Return
Please be sure to speak to your CPA and decide what method, cash or accrual, is required when filing your tax return. The IRS has specific guidelines on how to make your choice. For example, if you have inventory, you should likely be filing your tax returns using the accrual method. Here is what the IRS says in its publication 334: “. . . if an inventory is necessary to account for your income, you must generally use an accrual method of accounting for sales and purchases”.
Many accounting experts agree that the following taxpayers are required to use the accrual method of accounting:
- Businesses with income (sales) of more than $5 million per year; or
- Businesses that have an inventory of items that it will sell to the public and whose gross receipts are over $1 million per year. (Inventory includes any merchandise a taxpayer holds for sale as well as supplies that will physically become part of an item held for sale.)
The wrong accounting method selection could trigger an IRS inquiry and even an audit.
Please see Publication 334 Tax Guide for Small Business