There are two forms of accounting that can be reported on an income tax return: cash and accrual. Most small businesses operate using the cash accounting method. This is when income and expenses are realized when money is either received or paid out. For instance, if you invoice clients for services, you count your income when you receive the customer’s payment. You also count the expense once you have written the check to pay your vendor. The benefit of cash accounting is that it is easy, and your profit/loss is based on transactions in which money was exchanged.
Accrual accounting doesn’t count income/expenses when payments are sent or received. Instead, it counts income as soon as it is earned (an invoice is created) and an expense is incurred (a bill is received). The benefit of accrual accounting is that it gives a better picture of what is actually happening in the businesses (how much you owe and how much is owed to you).
Let’s look at an example to see how these two methods differ.
- Business invoices customers last day of the month. Total balance billed 12/31 is $15000.
- Business pays rent on the first, but bill received mid December for $500.00
- Business received payments on 12/31 in the amount of $3250.00
- Business paid some bills on 12/31 in the amount of $2650.00
In the cash method, the total income from these transactions is $600.00 ($3250-$2650). Using the accrual method, the income would be $15,100 ($15000 – $500 + $3250 – $2650). Many businesses often don’t get paid for a few months after invoicing, so it can have a huge impact on cash flow (the business has to pay tax on these profits even without the cash having been received).
Understanding the differences and how it will impact the taxes you pay is important. Not sure how you should report your income? Talk with your CPA to find the best solution for you.