Every small business must keep a record of its income and expenses. The IRS requires that each business uses an accounting method to show all financial transactions clearly. There are two methods that are typically used for accounting; the cash method, and the accrual method. It’s an important decision and unless your business legally requires you to use one or the other, you must choose the method that works best for your needs. Your choice is called your basis of accounting. Both methods have positives and negatives and your choice can affect your finances in more ways than simply how you do your taxes.
Using the cash method is the most commonly used basis of accounting. When using the cash method, your income is not considered taxable until you have constructive receipt of the money.. In other words, you only account for income on the date that you have access to the money.. The same goes for any expenses. You are able to deduct expenses when your vendors have receipt of your payment.The cash method is great for small businesses to provide a more accurate record of your businesses cash. Another benefit is that if you need to lower your tax debt in a particular year, you can request your clients delay in paying you. The downside is that using the cash method can be misleading when it comes to your long-term profitability. For example, the books may show you had a very profitable month, when in fact you may have been very slow but had several clients pay for previous months.
With the accrual method, any transactions are counted when they occur, regardless of when payment is made. Instead of recording a transaction only when money enters or leaves your account, you can record them when the sale is made or the services are provided. A benefit of the accrual method is that it provides a better view of your fluctuating profitability. However, using the accrual method can lead to serious cash flow problems because it doesn’t accurately show the money you actually have available. You may show a large sum for services, but if those services haven’t actually been paid for, the actual cash will not be at your disposal. As far as taxes are concerned, deductions for expenses can be taken on your returns even if you haven’t fully paid for the items or services. Law requires the accrual method for businesses with sales in excess of five million dollars or if you stock and sell items with receipts totaling over one million dollars. It is also required for partnerships and tax shelters, as well as some specified farm organizations.
Cash vs. Accrual Accounting: How Do I Choose?
When making a decision for your business, it is important that you fully understand the two systems and know the advantages and disadvantages of both. Doing your research can save you a lot of trouble and expense in the long run, even if you aren’t an accounting whiz. You also must examine your own business model and compare each method to how you operate.
The professionals at Landwehr Financial Services can be a great help in deciding what works best for you. Our holistic approach ensures that we will take the time needed to truly understand your situation and make your accounting concerns disappear. Contact us today to learn more about our services and experience first-hand the level of care we give to all our clients in the St. Cloud MN area. We are happy to discuss your tax needs, as well as any other accounting services you require.