Every business, small or large, must make a decision about how and when to record income and expenses. For tax purposes, you will need to make this decision for your business before you file your first business tax return, using one of two accounting methods – cash or accrual.
The decision to use cash or accrual accounting has a big effect on your business tax return and ultimately your bottom line.
Tax Law Changes and Accounting Options
The 2017 Tax Cuts and Jobs Act allowed for a change in the option to select cash accounting instead of accrual. More small businesses can elect to use cash accounting, beginning in 2018. You can use the cash method if you had average annual gross receipts of $25 million for the preceding three years. Some small businesses may also be exempt from certain accounting rules for inventories, cost capitalization, and long-term contracts.
If your business currently uses accrual accounting, you'll need to use IRS Form 3115 to apply for a change in accounting method. Qualifying for these changes may be complicated; get help from your tax professional before you make the change.
How Cash Accounting Works
In cash accounting, a transaction is recorded when money actually changes hands. Income is recorded when you receive the money and expenses are recorded when they are paid.
Example 1: For an income transaction, if you perform a service and bill a client, you record the income for cash accounting purposes only when you have received the payment for that service. If you send out an invoice on August 12 and you don't receive payment until September 1, you record the payment on September 1.
Example 2: For an expense transaction, you might receive a bill for phone service, but in cash accounting, you don't record the expense until you have actually paid the bill. if you receive a bill on August 15 and you don't pay the bill until September 1, you don't record the expense until September 1.
How Accrual Accounting Works
In accrual accounting, you can deduct business expenses when either
- Liability has been fixed or can be determined with reasonable accuracy, or
- Economic performance, when property or services are provided or property is used.
In Example 1: For an income transaction, using the accrual method, you would record the income when the work is complete or the product has been received; that is, you have earned the payment. In the examples above, income to you is recorded when you send out the bill, even though you have not yet been paid. The liability is recorded when you receive the bill, even though you have not paid.
In Example 2: For an expense transaction. When you receive a bill for an expense, it's considered a liability. So you can deduct it for that year, even if you haven't paid the bill yet.
Prepaid expenses are a special case. In general, you can't deduct expenses in advance. For example, if you paid for internet service for five years, you can only deduct the cost of one year on your business tax return for the year.
|Cash Accounting vs. Accrual Accounting|
|Cash Accounting||Accrual Accounting|
|Income is recorded when you receive payment.||Income is recorded when you earn payment and send the bill.|
|Expense is recorded when you are paid.||Expense is recorded when you receive the bill.|
Pros and Cons of Accounting Types
Cash accounting is simpler to remember and record since it follows your business checking account. When a sale is recorded in your checking account, it's recorded in your business. But the cash accounting method may not show the real picture of your business activity since the month you were busy or slow is different from the month when you received the money.
Accrual accounting is more confusing, but it shows your monthly business activity more accurately.
Setting Your Accounting Method
Once you set your accounting method, you must continue to use it from year to year, and the method you select must clearly mirror your income and expense.
If the IRS doesn't think your accounting method reflects your income, they can refigure your income using the other accounting method.
Most small companies use the cash method of accounting because it is simpler and easier to figure out when to record income and expenses. In general, if you produce, purchase, or sell merchandise and have an inventory use the accrual method. But the new law described above may allow you to use the cash method.
End of Year Transactions and Accounting Method
At the end of your fiscal (financial) year, cash and accrual accounting must be considered in the timing of transactions. Here is how:
- Income: If you are using accrual accounting and you want income in the current year, send out bills before the end of the year. If you want to delay income, don't send out bills until after the start of the next year. For cash accounting, pay the bill in the year when you expect the lowest total income.
- Expenses: Take on expenses in the year when you want those expenses to be counted, to minimize your taxes. You don't necessarily have to pay the bill in that year if you are using accrual accounting.
Un-collectible Bills/Bad Debts
You don't have bad debts if you're using the cash method of accounting because you don't record the debt until you receive the money. Under the accrual method, if you have customers who haven't paid you, you may be able to write off or reduce your taxes for these bad debts. You can only claim a bad debt deduction for an uncollectible receivable if you already included it in income.
As an example, let's say you sent an invoice to a client in February. You have made repeated attempts to collect the money and have finally decided that this client is not going to pay. If you are using the accrual accounting method, you have already recorded the sale. Before the end of the year, you may take this uncollectible amount out of your income, thus reducing your gross income and your tax liability.
How to Change Your Accounting Method
Once you have set your business accounting method, you must get IRS approval to make a change to the other type. How you treat different types of income and expenses must be consistent for tax purposes.
You will need IRS approval if you want to change:
- From cash to accrual or accrual to cash
- From one way to value inventory to another (FIFO, LIFO or another valuation method)
- From one depreciation method to another
You can file IRS Form 3115 to make any of these changes, including the new change described above. You will need a designated change number (DCN) describing the type of change you want to make. You can find a list of these DCN's in the instructions for Form 3115.
For More Information
For more information on IRS restrictions on accounting methods, see this section of IRS Publication 538: Accounting Periods and Methods.
The information in this article is not intended to be tax or legal advice. The qualifications and requirements are complex. If you are unsure about which accounting method to select or you want to make a change in your accounting method, check with your professional tax advisor first.
IRS. "Tax Cuts and Jobs Act: A Comparison for Businesses." Accessed July 9, 2020.
IRS. "Instructions for Form 3115 Application for Change in Accounting Method." Page 1. Accessed July 9, 2020.
IRS. "Publication 535 Business Expenses." Page 6. Accessed July 9, 2020.
IRS. "Publication 535 Business Expenses." Page 6. Accessed July 9, 2020.
IRS. "Publication 538 Accounting Periods and Methods." Page 8. Accessed July 9, 2020.
IRS. "Publication 535 Business Expenses." Page 41. Accessed July 9, 2020.