Deciding between cash and accrual accounting methods
Small businesses typically begin with the cash-basis accounting technique. However, many eventually switch to accrual-basis reporting to comply with U.S. Generally Accepted Accounting Principles (GAAP). So which of these accounting methods is best for your business?
Companies that use the cash method record revenue as customers pay invoices and expenses when paying bills. As a result, cash-basis firms may occasionally report variations in earnings, mainly if they are working on lengthy projects. Because of this, comparing a company’s success year to year or against other organizations that employ the accrual technique is challenging.
Annual taxable income is adjustable for businesses qualified to use the cash method of accounting for tax reasons. To do so, you must strategically choose the year you declare your deductions and recognize your taxable income.
Usually, deferring revenue recognition and accelerating expense payments at year-end is the desired course of action. This tactic may temporarily postpone the company’s tax liability. However, it gives investors and lenders the impression that the organization is less profitable.
The reverse strategy, accelerating revenue recognition and deferring expenses until year-end, may be favorable if tax rates rise significantly in the upcoming year. With this plan, the corporation can maximize its tax obligation for the current year, when rates should be lower.
The more complicated accrual method complies with GAAP’s matching concept. In other words, businesses record income (and expenses) when it is earned (or incurred). This approach makes financial benchmarking easier by minimizing significant profit swings from one quarter to the next.
Several asset and liability accounts that are typically missing from a cash-basis balance sheet are also reported by accrual-basis organizations. Some examples include prepaid costs, accounts receivable, accounts payable, work in progress, accrued costs, and deferred taxes.
The accrual approach is essential for public companies. However, small businesses have other choices, such as the cash approach.
Tax considerations for business accounting methods
More businesses are now qualified to employ the cash method for federal tax purposes than were previously allowed to do so, thanks to the Tax Cuts and Jobs Act (TCJA). As a result, several small businesses have had to reconsider how they keep their books organized.
According to the previous three tax years, the TCJA expanded the definition of a small business to encompass entities with typical annual gross receipts of no more than $25 million. This cap rises each year to account for inflation. The adjusted ceiling is $26 million for tax years starting in 2021. It will cost $27 million in 2022. The gross receipts threshold for the cash method was a mere $5 million under previous legislation.
Additionally, the TCJA amends Section 451 of the Internal Revenue Code. The amendment states that a company must record revenue for tax purposes as soon as it is recognized for financial reporting purposes for tax years beginning after 2017. Therefore, you must use the accrual technique for federal income tax purposes if you use it for financial reporting purposes.
Choosing your business accounting methods
A small business may decide to move to the accrual accounting method for several good reasons. It can aid in lowering financial reporting unpredictability and draw in funding from financiers and investors who favor GAAP financials. However, suppose the cash method is available to you for tax purposes. In that case, you might choose to switch to it because of its simplicity and flexibility for tax planning. Contact our RRBB accountants and advisors to discuss your choices and choose the best course of action.
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