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One of the most important accounting decisions a small business must make is how to handle its financials. Specifically, as a small business owner, you must choose your method of accounting for purposes of filing taxes. An accounting method is the basic guidelines and rules used to keep financial records and prepare financial reports. Generally speaking, you have a choice of being a cash basis or accrual basis taxpayer.
What Is Cash Basis?
A cash-basis business recognizes income when it is received and deducts expenses when they are paid. For example, if your business' fiscal year follows the calendar year, income represented in the invoices that are issued in December, but that not paid until January, will count as revenue for the new tax year.
What Is Accrual Basis?
Businesses who follow an accrual basis for tax purposes, recognize income when it is earned and deduct expenses as they are incurred. This is done regardless of when it was paid and without regard to the actual timing of cash receipts or payments made. The accrual method incorporates accounts payable and accounts receivable, which can provide a better picture of the company's health over time.
Can My Small Business Choose Cash Basis?
Before answering the question, "should my small business be a cash or accrual basis taxpayer," you must first know whether your small business can opt to use the cash method of accounting for tax purposes.
In most cases, your business is permitted to use the cash basis unless it is:
- Specifically prohibited from using the cash method, or
- Specifically required to use the accrual method.
Recent new tax law changes in the Tax Credit and Jobs Act (TCJA) of 2018 made it less restrictive to be a cash basis taxpayer, as long as your average annual gross receipts from the previous three years did not exceed $25 million. Under previous law's more restrictive rules, a lot of small businesses could not be cash basis.
Fast-growing companies and startups with investors might require GAAP financials, which follow the accrual method of accounting. These businesses still might opt for a cash method for tax filing purposes, but they should consider the additional burden and expense of maintaining two sets of accounting books.
Advantages of Choosing Cash Basis
The cash basis of accounting provides small businesses with more flexibility. Cash basis accounting is simple and straightforward. Additionally, the cash method of accounting provides a clearer picture of the actual money your company has on hand.
- Simplicity: The cash method of accounting is easier and less expensive for businesses to implement and maintain.
- Flexibility: The cash basis allows for greater tax-planning flexibility because you can control the timing of income and deductible expenses. For example, your small business can defer income to the next tax year simply by delaying the issuance of invoices. Your business also could shift deductions into the current year by paying expenses in advance.
- Cash flow: Because under the cash method income is taxed in the year it is actually received, this method ensures your business has the funds on hand to pay its tax bill.
Does your small business need more guidance on the accounting choices you have? Contact the expert CPAs at AccountedFor, for answers to your tax filing and accounting questions.