If you’re an entrepreneur or small business owner, it’s a good idea to familiarize yourself with cash and accrual accounting methods.
What is the cash accounting method?
So, what is the difference between the cash accounting method and the accrual accounting method? According to the IRS, the cash and accrual accounting method is one of the most common accounting methods.
IRS Publication 538 (01/2022), Accounting Periods and Methods, breaks down the two methods. First, the cash accounting method is when money flows into or out of the company, the transaction is reported as cash in the same year, and the expense can be reported in the tax year in which it was spent.
What is the accrual accounting method?
The accrual basis, on the other hand, is when small businesses report their income for the tax year, regardless of when it was received. At the same time, these charges are deducted in the year in which they were incurred, regardless of when the actual payment was made.
Regardless of which method a small business uses, the IRS states that a consistent payment method must be used.
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Q&A | Accrual vs Cash Accounting Example
TheStreet provides year-round financial and tax strategies with our partners at TurboTax. Our Retirement Daily’s Robert Powell caught up with CPA and tax expert Jeffrey Levine of Buckingham Strategic Wealth Partners for a Q&A on two common accounting methods below.
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Robert Powell: Jeffrey Levine of Buckingham Wealth Partners has three things for sure when it comes to life, death, taxes and taxes. Jeffrey, when we think about tax tips, there is a question related to being an independent entrepreneur and whether they should use cash or accrual accounting.
Why Most Entrepreneurs Choose Cash Accounting
Jeffrey Levine: Absolutely. When people decide whether to use the cash basis or the accrual basis, the first thing I talk to them about is that the cash basis method is much easier. That’s why the vast majority of small businesses that qualify for this method use it, because as ordinary taxpayers, the ones on our personal tax returns, we use the cash basis to pay taxes on almost everything.
Now, the cash basis approach means that when you pay what is considered paid, it seems to make sense, right? When you pay, you have expenses. When you earn income, you actually record income.
Examples of accrual accounting methods
Accrual is a bit brutal because it’s so much more complicated. For example, let’s say Bob, I’ve agreed to do some project work for a company, I’ve done all the work, they haven’t paid me yet, but I’m done. So the accrual basis actually matches the revenue for that contract, right? I’ve done all the work, so I have to record that income now, even if that company hasn’t paid me yet. Maybe they won’t pay me for another two or three months, and sometimes it may span different years. Therefore, using accrual accounting can become more complicated. We didn’t really take that into consideration.
Quotes | Accrual vs Cash Accounting: What’s Best for Small Businesses?
Jeffrey Levine, Chief Planning Officer, Buckingham Strategic Wealth
Jeffrey Levine, Chief Planning Officer, Buckingham Strategic Wealth
Now, the reason big companies do it right is that if you’re a Fortune 500 company and you trade on a stock exchange, you tend to use the accrual basis because it’s a more precise way of recording. Because if I don’t get paid two months from now, well, I still have income, right? If I have done all the things I need to do to get paid. I’m just waiting for the check to arrive, but it lets investors know that I’ve done something to generate income.
Example of Cash Accounting Method
On a cash basis, maybe I have a supplier who doesn’t pay me. In fact, you know, if you imagine you’ve done all this work, they just write you a check on December 31st every year for your entire year’s worth of work. Well, on December 30th, you don’t seem to be doing anything. You have no income. You do nothing. But on December 31st, you seem to have the best day in world history. Now, none of this is true, but in a cash-based system, this is what it looks like.
In an accrual based system you actually get that income and I’m oversimplifying it here for people to understand but you actually see income being earned throughout the year because you’re really doing this work. The fact that you get paid on December 31st doesn’t really affect how your business performs on paper.
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