Do I Need to Report Cash Basis or Accrual?
As a business owner, navigating complex financial topics can be challenging. However, getting to the root of financial decisions that significantly impact an organization is critical. One such decision lies in business accounting. Every organization must decide which accounting method is best to manage and record income and expenses.
Cash basis and accrual basis are the two primary options, each with significant effects on your business tax return. In the content below, we discuss the differences between cash basis and accrual basis accounting, the benefits and disadvantages of both, and if you need to report cash basis or accrual. As a result, you can better determine which accounting method is best for your business.
Cash Basis vs. Accrual Basis Accounting
The primary difference between the cash basis accounting method and an accrual-based accounting process lies in both the timing and recording of sales and purchases.
Cash Basis Accounting
In the cash basis accounting method, revenue is reported at the completion of a cash transaction or purchase. Likewise, expenses are recorded once cash is paid out. Cash basis accounting does not consider accounts receivable or payable.
For example, if you complete a service and send the client an invoice, you will record the revenue once the bill is paid. If you sent the bill on September 10th and received payment on September 17th, income would be recorded as received on September 17th.
The same methodology applies to expenses. If you pay an invoice three days after receiving it, the expense is recorded the day the money is transferred from your account.
Accrual Basis Accounting
The accrual basis accounting method records revenue when the product is delivered, expecting reimbursement in the future. Revenue is accounted for once a value is earned. Expenses are recorded in the same way as they are recorded even before payment was taken from your account.
In reference to the cash basis examples above, accrual basis accounting would record payment on September 10th and document the expense at the arrival of the invoice.
Cash Basis vs. Accrual Basis: Pros and Cons
Cash Basis Pros:
- Cash basis accounting mirrors your business checking account. Many individuals utilize a cash basis method of recording income and expenses in personal finance.
- Ease of use.
- Improves cash flow management.
- Income tax benefit. In the cash basis accounting method, taxes do not have to be paid on transactions until money has been received. Thus, if you sent a bill in November and are reimbursed in January, taxes on that income would be paid the following year. For small businesses with rigid funds available for tax payments, this offers invaluable benefits.
Cash Basis Cons:
- Can be deceptive. While the cash basis accounting method allows for short-term analysis of financial health, it does not provide an accurate assessment of long-term wellbeing. Therefore, a company may look inaccurately unprofitable to an investor, simply because revenue is only expected as it is received.
- No records of accounts receivable or payable. As mentioned, cash basis accounting does not require documentation of accounts receivable or payable. This can create confusion if outstanding payments or bills are due.
- Does not conform to Generally Accepted Accounting Principles (GAAP). The GAAP states that businesses making over $25 million in sales yearly must utilize the accrual basis accounting method. Thus, if it appears that your business may exceed this soon, the cash basis method is only viable for this current period.
Accrual Basis Pros:
- Widely popular. Accrual accounting allows for a smooth view of earnings over time because revenue and expenses are regularly recorded. Cash-basis provides an intermittent view of earnings.
- Records business activity accurately. Accrual basis accounting allows for a precise long-term picture of your company’s financial health. A long-term perspective can help businesses make profitable, informed decisions and track consumer behaviors.
- Conforms to GAAP. As mentioned, accrual basis accounting must be utilized by companies exceeding $25 million in sales yearly.
Accrual Basis Cons:
- More confusing and complex.
- Cash flow must be tracked separately.
- Unclear short-term picture of financial health. Because of this, a company with severe cash shortage may appear extremely profitable in a long-term perspective.
Do You Need to Report Cash Basis or Accrual?
Selecting the right accounting method for your business is important because your company can’t switch halfway through the tax year. However, if one method does fit with your business goals or financial requirements over time, the IRS may approve companies to adjust utilizing accounting methods with IRS Form 3115.
Did your business acquire $25 million or less in revenue within the past three years?
Perhaps the most important consideration lies in qualification. Prior to December 31, 2017, every business with an inventory was required to utilize accrual basis accounting. However, the 2017 Tax Cuts and Jobs Act allowed qualifying small businesses to select cash accounting. Simply, most small businesses that have made less than $25 million in revenue within the past three years can qualify for cash basis accounting.
Does your business stock inventory items, sold to the public, with gross receipts of over $1 million yearly?
If the answer is yes, you are required to utilize accrual basis accounting Even if your small business qualifies for the previous requirement, merchandise sold directly to consumers requires the accrual method. However, it is important that you properly exercise efficient inventory management to prevent buying inventory you cannot afford or miscalculating your projected inventory sales.
Does your business regularly sell more than $5 million yearly?
If so, you must use the accrual accounting method. If not, cash basis is an option.
Are you looking for a simple method?
Qualifying small businesses, including many sole-proprietorships or partnerships, often choose cash basis accounting due to its simplicity. Only cash paid or received is documented, and tracking cash flow is simplified.
Establish Your Reporting Process with Remote Quality Bookkeeping
Are you unsure whether to choose cash basis or accrual basis accounting? Reach out to us! At Remote Quality Bookkeeping, we are in the business of simplifying your business accounting needs.
Our cloud bookkeeping service allows us to have top-level staff working together on your account. Business owners can focus on the other important aspects of running a business while our experts focus on the health of your financial account.
To learn more about simplified bookkeeping solutions for your business, please reach out at 866.567.4258 or via our online contact form!