Accrual vs. Cash Method of Accounting
When you start a small company, one of the first decisions you will need to make is what technique of accounting you will implement.
Presently there are two ways of accounting that happen to be approved for federal tax purposes – Accrual and Cash -. There are some distinctions between the two; however, the primary distinction is the timing of transactions.
You will need to examine the pros and cons of each, before choosing which approach to employ in your company.
When selecting which accounting strategy to use for your small company, it is vital that you be conscious that while most small corporations can select their method, others are not able to. Any time your organization matches either of the following two criteria, you need to use the accrual method:
A. The sales for your business exceed $5 million annually or
B. You have an inventory of items that is held for sale to the public along with gross receipts exceeding $1 million per year.
Most small organizations choose to use the cash method of accounting. Under the cash method, income is recognized when it’s received, not when you bill a client. Expenses are similarly recognized when the money is paid out, not each time a vendor bill is received.
The accrual method is based more on when transactions take place, as opposed to when you receive or pay out cash.
Even for those who have not yet received the money from a client, income is recognized when the sale takes place instead of when you receive the cash. The same holds true for recognizing expenses; you do so when you receive the goods or services, not when you actually pay for them.
The accrual method of accounting often times will show you a more accurate picture of how your business is performing because it follows the income and debts, which is an advantage.
On the other hand, the accrual method does not always give you an accurate image of cash readily available. Not knowing how much cash on hand a business has lead to cash flow problems. The accrual method can also require more bookkeeping since you will have to track of accounts payable and accounts receivable.
For bookkeeping reasons, the cash method of accounting may end up being less complicated to maintain. The cash method also gives you a more precise awareness of money available. A drawback to the cash method, is since you are not checking future income and expenses, you may have a unreliable view of future profitability.
Many business owners question if selecting one method over the other can save them tax. When a company is expanding, often times it will have more accounts receivable than accounts payable. Using the cash method in this case would create a decrease in tax burdens, since earnings are recognized only when received, rather than having to recognize all accounts receivable.
Choosing which method of accounting to use for your business is a big decision. It is beneficial to discuss with an accounting professional which method helps make the most sense for your business.
For additional information concerning your personal or business accounting needs, please contact Huddleston Tax CPAs by visiting the website: http://huddlestontaxcpas.com
