The method of accounting you decide to use can determine how you show the profit of a business in a particular year under review.
This directly affects the income taxes that your business will pay to the government, and the impact may also determine whether you are able to obtain a loan or raise investments. Unlike other accounting choices in business, you can't choose what's best for your business on yearly basis— it will be better and advisable to make a choice and stick with it for the long term.
Difference Between Cash Basis And Accrual Basis Of Accounting
The method of accounting which your business adopts will determine when transactions should be reported on your financial statements. The two accounting methods are cash and accrual. The cash method is named because you record a transaction as soon as you receive cash for the transaction. On the other hand, in accrual method, accrued income and expenses are reported when they were earned or incurred irrespective of when the cash changes hands i.e when the business receives cash from customers.
For instance, assuming you sell a product on 15th November, 2000 and the customer pays $500 for the product on 15th February, 2001 as you agreed. In the cash method of accounting, the $500 is recorded as income on 15th February, 2001 when the cash is received and, if your tax year follows the calendar year, goes on the year 2001 taxes. In the accrual method, the $500 is recorded on 15th November, 2000 and would aly be taxed in the year 2000 even though you didn't receive the payment until year 2001.
Cash Vs Accrual Accounting Advantages And Disadvantages
When choosing an accounting method, the most important thing to understand is that the accounting method you choose doesn't affect your profit or lose. It only affects when a transaction is recorded. While your taxes might be slightly impacted depending on your tax bracket, if the method you chose increased or decreased your taxes in a particular year, that difference will generally be offset in the following year.
Cash Basis Accounting Method
Simplicity is the key advantage to the cash method. You can easily look at your checkbook and sales receipts to calculate your profits and losses for the year. In the cash method, You can also know the exact amount of cash you have at any given time.
The disadvantage is that when you receive or send cash may not accurately reflect when you actually earned or spent it.
Accrual Basis Accounting Method
The major advantage to the accrual method of accounting is smoothing out your profits and losses. When you make or receive a large payment for something that happened over a period of several months, accrual accounting divides the transaction over those months.
The disadvantage of the accrual method is that it is very complex and takes extra work to figure out how all of your transactions should be recorded in your books. In accrual method, you need to keep separate cash flow statements to know how much cash on-hand you have at any given time.
How To Choose Between Cash Basis And Accrual Basis Accounting
Generally, you are free to choose either method for any reason at all, it won't affect the profit and loss of your business. Many small businesses use cash accounting because it's easier than the accrual method. If you are looking to raise funds for your business, outside investors usually prefer to see books of account using the accrual method so they can see the big picture of the company's financials.
You must use the accrual method if:
- Your average annual gross receipts over three years is in excess of $5 million.
- You hold products in inventory and your gross receipts exceed $1 million per year.
- You are a publicly traded company that is required to follow Generally Accepted Accounting Principles (GAAP)
Cash Basis Vs Accrual Basis: Changing Accounting Methods
Businesses are not freely allowed to change their accounting methods to prevent them from using changes to avoid taxes or manipulate taxes. As soon as you have selected your accounting method and filed taxes under that method, you must request IRS approval if you want to change your accounting method. If an approved change results in an adjustment to your taxable income, you will need to pay (or receive credit for) the difference in the tax year in which the change is approved.