Cash Accounting vs. Accrual Accounting
Even if you don’t handle your own financial reporting, it is vital for you to know the difference between cash and accrual accounting. The variance lies in the timing of when sales and purchases are recorded, but the method you choose can significantly impact your taxes.
When using the cash method, you record transactions as they happen. Revenues are not recognized until the payment is received, and expenses are not recognized until they are paid. Any accounts receivable or payable are excluded, and transactions are not acknowledged until cash is in hand, or until a check has cleared your bank account. This is a more simplified version of bookkeeping, and often the easiest method to maintain. This technique is common in small businesses, as it is easier to track money, and your organization will not have to pay income tax on revenue until it is actually deposited in your account.
With the accrual method of accounting, transactions are recorded as they are earned or billed, regardless of when the money is received or paid. If you invoice a client in October, you record that income in October, even if that client does not actually pay you until December. This can give business owners a more realistic long-term picture of their finances, but does not take cash flow into account. This can be financially devastating for a small business if cash flow is not carefully followed.
Example: You invoiced a client for $5,000.00 on December 12th, 2016. The client pays you and the check clears your bank on January 18th, 2017.
If you are following the cash method, you would record the $5,000.00 as part of your 2017 income.
If you are following the accrual method, you would record the $5,000.00 as part of your 2016 income, and thus pay taxes on it.
If your small business sales less than $5 million a year, or does not require you to keep inventory of merchandise to sell to consumers, you are free to choose which method your business will maintain. However, if you make more than $5 million worth of sales a year or sustain an inventory, you are required by the IRS to use the accrual method.
While neither method is perfect, make the most of your option to choose by understanding what these methods entail. As always, when making a significant accounting decision consulting a professional can help you feel confident that you’ve made the best choice for your business.
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