Know your Accounting Method

Every small business uses one of the two accounting methods, cash or accrual accounting. The main difference between the accounting methods is the timing when expenses and revenue is recognized and reported for taxes.

Cash Accounting

The cash method is most commonly used because it is simple to use and takes cash flow into consideration. It is accounting for expenses only when they are actually paid out and for revenue when the money is actually received. Income is not taxed until received.

Accrual Accounting

Gives a better idea of real income and expenses over a period of time. It is more complicated than the cash method and cash flow is less transparent. The accrual method recognizes expenses and revenue in the period incurred not when the cash is paid out or received. It matches expenses with revenue more closely.

Example showing the difference between Cash and Accrual Method

A company paid business insurance for 3 months in advance in November for $300 for period November through January.  With the cash method the entire amount of $300 is recorded as insurance expense in November. Under the accrual method only $100 are recorded as insurance expense in November and $200 are deferred expense and, therefore, recorded as prepaid insurance, an asset account on the balance sheet. In December $100 is recorded as insurance expense on the books and the prepaid insurance is reduced by $100. The same recording is done in January resulting in 0 balance on the prepaid insurance account.

When you have to use Accrual Accounting

1. If a business generates sales of more than $5 mil
2. If a business carries inventory of $1mil and above
3. If a business is a government contractor

Do you know your Accounting Method

Businesses should ask their accountant what method they are using. Generally, a business establishes their method with the first tax return filed to the IRS. The IRS acceptance of the return is the approval for the method and that method has to be used consistently for all future tax filings. However, there are certain changes to the accounting methods that will require explicit IRS approval:

• If in later years a change of accounting method is requested such as Cash to Accrual or vice versa
• A change in the depreciation or amortization method
• A change in the method or basis used to value inventory
• Basically any material change needs approval

For more detailed information refer to Page 20 Publication 538