Joshua V. Azran, partner/owner of Azran Financial (www.azranfinancial.com) discusses the differences of cash and accrual accounting for your small business.
- Different methods of reporting for tax & financials is allowed by the IRS
- Cash accounting- income or expense recorded when cash is received
- Accrual accounting- income or expense recorded at time of performance
A lot of startup businesses and some even established businesses run into the question of keeping their books and records and also for tax reporting either on a cash or accrual basis.
So, in examining this, let’s start off with the basic definition of what cash versus accrual accounting is and then we’ll look at some of the implications of both.
Cash accounting or cash basis accounting as it’s referred to is going to be when income or expenses recorded at the time of cash being received. We’ll make this distinction from accrual accounting because accrual accounting will recognize income or expenses at the time of performance. That performance does not necessarily include a transaction of cash and therefore, distinct – differentiates itself from the cash basis of accounting.
An important consideration is that your records and books do not need to necessarily be on the same basis as your tax reporting. The IRS does permit different methods for tax versus financial reporting purposes.
Generally, the cut off point is if your gross receipts are under 10 million, you have the opportunity to report on a cash basis. In certain circumstances, reporting on a cash basis maybe more favorable than on an accrual basis.
Let’s start with a really simple example. You have a small business and you sell an item for $100. If we’re thinking about this on a cash basis, you will recognize the sale when you actually receive the cash for that $100. Conversely, in a simple accrual basis example, you’ll recognize that sale at the time the merchandise is transferred and what we consider the sale to be final.
There are some additional complexities along with this and this is one of the reasons that many companies shy away from accrual basis accounting on their early stages. Let’s take another example.
So, again with the same $100 item that’s sold, let’s be on the other side of that transaction. So, if we’re the one purchasing the item and we pay cash for it in a cash basis transaction, we would then recognize that – transaction at that time.
However, if this was an accrual based company and we did not transmit cash at that time, we wouldn’t necessarily recognize the cash going out but if we did receive the benefit, we would at that time recognize liability.
These are one of the differences between the cash and the accrual basis. One of the simplest things to differentiate is that the accrual basis will have things like accounts receivable and accounts payable. Therefore, representing the differences between when an action or item is performed and when the cash is actually received.
In a true strict cash basis, we’re only going to be recognizing those transactions when cash actually changes hands. Therefore, in theory, we would have no receivables and no payables actually, too.
Many small businesses will tend (inaudible) using cash accounting. This is especially true of very small businesses in sole proprietorships. However, because of the complexities that are – exist around things like revenue recognition, cash versus accrual accounting becomes a more complex issue and that also becomes an even more complex issue when we look at it in the context of tax purposes.
For these reasons, it’s best to seek professional advice when making the decision about whether you want to operate your company and or report for tax purposes either on a cash or accrual basis.