Cash vs. Accrual Accounting – The Tax Perspective

By William Colangeli, CPA

Several business decisions you make affect your tax obligations each year. One of those many decisions is the accounting method you use to record your business transactions. As a business, the taxes you pay are based upon the net income of your company for the year. Net income is defined as sales less expenses, so how you determine your sales and expenses (i.e. your accounting method) is a significant factor in the taxes you pay each year.

Thus, the question arises, when do I have a sale or an expense? It depends on your choice of accounting method. You had to choose a method of accounting the first time you filed a tax return for the business. Sometimes, the accounting method is dictated by the IRS code. However, many small businesses are free to choose their method of accounting. Once you have chosen a method though, it is typically permanent, but it may be changed with IRS permission.

There are two main methods of accounting, the cash method and the accrual method. Each method will typically result in a different amount of net income. Therefore each method usually results in a different amount of taxes to be paid.

Sales

Most small businesses prefer the cash method of accounting. The main reason is they do not want to be taxed on what they consider “phantom income”. “Phantom income” refers to receivables, invoices that you have sent to your customers for which you have not received payment. It is the money that customers owe to you. Under the cash method, this money is not considered sales until payment is received, either by check, cash or credit card. Therefore, you only report as income those payments you receive during the year.

Under the accrual method, these receivables are considered sales at the moment you invoice the customer. When you receive payment is irrelevant. The act of sending your customer an invoice makes it a sale at that moment, under the accrual method. This means that you will be reporting these amounts as income even though you have not yet been paid.

Expenses

As mentioned earlier, taxes are paid on net income and net income is derived from sales less expenses. With the cash method, an item is an expense at the time you write the check, pay cash or pay by credit card. This means you deduct items only when you pay them. Under the accrual method, you have an expense when you owe an employee or vendor money for services they have provided or products they have sold to your business. Notice the emphasis on when you owe. The idea here is that you don’t owe money to another party unless you “ordered” something and they have fulfilled their part of the transaction. Usually at that point, you are obligated to pay (i.e. you have incurred a bill) and that item is considered an expense. Under the accrual method, you can deduct an expense even though you may not have paid for the item.

As you can see from this discussion, the cash method is payment driven. You have income when you receive payments from your customers and you have expenses when you make payments to employees or vendors. The cash method is very “check-book” oriented.

The accrual method is tied to when “paper” moves. “Paper” tends to move when someone feels they have the right to bill someone else. The “papers” are the invoices you send out and the bills you receive. Accrual is more contractually driven, i.e. do I have the right to get paid (invoices you issue)? Am I obligated to pay others (the bills you receive)?

Choosing A Method

How do businesses go about choosing one of these methods? In most cases it comes down to receivables and payables. If a company thinks receivables will be greater than payables, they tend to favor the cash method. When payables tend to be higher, they typically choose the accrual method. For example, many service-oriented businesses tend to have receivables much greater than payables and thus they tend to report using the cash method.

It may seem simple enough to choose one method or another but there are several other items that must be considered. For instance, sales tax must always be collected under the accrual method. You are required to collect sales tax when you invoice or at the moment you sell a taxable item to a customer. Even if the rest of your accounting is done on a cash basis, this transaction must be accounted for under the accrual method.

Some other areas requiring special treatment are retirement plans and the buying and financing of equipment or vehicles for your business. For instance, you can deduct amounts you plan to contribute to a retirement plan, even before you put the money in the plan, regardless of your accounting method. When buying and financing equipment or vehicles, you also may deduct these items in the year you buy them, even if they are financed, and payments will be made over a period of months or years. Both of these items have the affect of reducing your income and taxes before you’ve paid the cash for them.

Ultimately, there are many things to be considered when choosing a method of accounting. In this article, I have only touched on a few of the basic areas of the cash and accrual methods and have simplified the concepts to get the basic ideas across. There is much more to know about your two accounting options, which is why I would urge you to consult a qualified professional before making any decisions. A qualified professional can assess your business and make a wise recommendation that will be appropriate to your specific situation.

William Colangeli, CPA is a partner at O’Malley & Colangeli, CPAs, PC located in Bedford, MA, a public accounting firm providing bookkeeping, financial accounting, tax and management advisory services to small and medium sized businesses. For more information on cash vs. accrual accounting methods, please call Bill at 781-275-8897 or e-mail him at wcolangeli@omalleyandcolangeli.com. www.omalleyandcolangeli.com