Your business is finally selling its product or service and the dream you’ve been working toward is coming to fruition. But tread lightly, my friend, because this dream can very quickly turn into a nightmare come tax time if you don’t correctly account for your sales revenue and costs.
Lucky for you, we’ve got your back. Below we’ve outlined the use cases for both accrual accounting and cash accounting. Depending on your business’s industry and size, you may be required by the IRS (or asked by your tax accountant), to track things one way or the other.
Cash accounting is very straight forward. You make a sale, collect the money, and record that sale in your books on the day you collect it. Similarly, when your business has an expense, you just subtract that transaction from your books when it occurs (e.g., when you write a check or pay a contractor). This is the most rudimentary form of keeping your cash flow in order and managing how much money your business has on hand. Regarding your business's taxes, it is also very standard, because you are only paying taxes on money you have received less money you spent.
Benefits of cash accounting:
- Simple and very straight forward
- You will know exactly when you received payments or paid expenses
- If your business is small enough, a bookkeeper can inexpensively manage your books for you
- You are only paying taxes on money you’ve actually received
Accrual Accounting is a little less straightforward. You make a sale, collect the money and record that sale in your books on the day the revenue or expense was incurred. The same goes for any business expense - you record them based on the dates on your bills, as opposed to when you pay them. This method of accounting is great for businesses that have long-term contracts with clients or receive payments via credit card. If you have a client that is locked into a long-term contract, you want that revenue to be reflected when the deal actually happens and is earned, as opposed to waiting weeks or months for when we finally receive their payment. This also ensures you won’t see huge spikes in cash - e.g., a 12-month contract would be smoothed out over 12 months vs all in one month, which is how cash-basis accounting would record the transaction. However when tax time rolls around, you record money when you earn or are billed for it (i.e., expenses), which is likely before you physically receive or spend some of it.
Benefits of accrual accounting:
- You record revenues and book expenses in the periods they relate to, rather than just when they are paid
- You can more easily plan for the future of your business because you can see historical trends
- Is closer to being compliant with GAAP (Generally Accepted Accounting Principles). Please keep in mind that while GAAP financials are always accrual, accrual financials are not always GAAP. Various GAAP rules apply based on certain industries, sizes, etc.
It should be noted that if your business made more than $5 million last year and is incorporated as a company, you are required to use the accrual method. If you hold and sell inventory as a source of revenue, the IRS lowers that revenue threshold to $1 million a year if you are a qualified taxpayer. For more information on what is means to be a qualified taxpayer, please see this page on the IRS website.
Unless your business exceeds $5 million dollars in revenue a year, you should take a look at how you’re currently keeping track of your books. If the future doesn’t look like the dream you’d imagined, don’t hesitate to make changes.