How To Decide Between The Cash vs Accrual Accounting Method

May 15, 2024

One of the foundational pieces of good accounting is consistency. In fact, consistency is one of the basic accounting principles. The consistency principle states that businesses should use and maintain the same accounting method and processes throughout their financial recordkeeping and financial reporting. The two most common accounting bases are accrual accounting and cash basis accounting, but there is also modified cash basis accounting. We’ll define and discuss all three of these and explain when each may make sense for your business.  

What is cash basis accounting?  

Cash basis accounting is the simplest of accounting methods and often the one used by solopreneurs and newer small businesses. When you use the cash basis accounting method, you recognize income when cash is received and recognize expenses when cash is distributed. Of course, revenue and expenses are captured in the period in which they were generated since this is the standard required by the matching accounting principle.  

Here’s a cash basis example:  

Let’s say you own a landscaping company that completes a $10,000 job in July, but you don’t get paid until October. Using cash basis, you would record your income in your October books, unless you are paid with a credit card. If you’re paid with a credit card, you would record the expense as paid when it is charged to the credit card.  

The benefits of cash basis accounting are that:  

  • It is simple to use and maintain.  
  • It can be used by companies of any size.  
  • You only have to pay tax on money you have already received, instead of invoices issued.  

The downsides of cash basis accounting include:  

  • It presents an incomplete picture of your business.  
  • You only have a day-to-day view of your finances.  
  • Does not comply with Generally Accepted Accounting Principles (GAAP) requirements  

How does cash basis work when it comes to taxes?  

When you use the cash method, you report income in the tax year you receive it and deduct expenses in the year they are paid. IRS Publication 538 provides the following tax guidance for companies using cash basis accounting:  

Reporting income on your taxes with the cash basis accounting method  

Cash-basis businesses should include all taxable income types in their gross income amount on their taxes. If you received property or services, you should include the fair market value (FMV) and include it in your income.  

The IRS considers income received according to the principle of constructive receipt. Constructive receipt considers an amount as income when it is credited to your account or made available to you with no restrictions – even if you do not possess it. For example, if you authorize someone to receive income on your behalf, you are considered to have received income when they receive it.  

Example of how cash basis works with taxes for your business  

To illustrate how income and expenses using cash basis accounting should be treated for tax purposes, the IRS provides the following example in IRS Publication 538:  

“You are a calendar year taxpayer. Your bank credited interest to your bank account in December 2021 and made it available to you. You did not withdraw it or enter it into your books until 2022. You must include the amount in your 2021 gross income, the year you constructively received the interest income.”  

It’s worth noting that you cannot hold checks or postpone taking possession of similar property from one tax year to the next since this would violate the “report when received” aspect of cash basis accounting.  

How are expenses under cash basis treated for tax purposes?  

When operating on cash basis accounting and reporting taxes, you must deduct expenses in the tax year you paid them, including expenses for which you are contesting liability. Note that you cannot deduct an expense paid in advance and you may need to capitalize certain costs based on the Uniform Capitalization Rules.  

What are the two tax rules for expenses when using cash basis and doing taxes?  

When you are using the cash method of accounting, you must deduct expenses in the tax year in which you paid them. This includes business expenses for which you are contesting liability. Note that you may not be able to deduct expenses that were paid in advance. Rather, you might be required to capitalize certain costs and expenses based on the Uniform Guidance Rules.  

How to treat expenses paid in advance using the cash method of accounting?  

There are two ways to treat expenses paid in advance on your taxes:  

  • The general rule: An expense paid in advance is only deductible in the year to which it applies (unless it qualifies for the 12-month rule)  
  • The 12-month rule: Note that you are not required to capitalize amounts paid to create certain rights or benefits that do not extend past the earlier of the following:  
  • 12 months after the right or benefit begins  
  • The end of the tax year after the tax year in which payment is made  

To begin applying either the general rule or the 12-month rule to paid-in-advance expenses, you must obtain approval from the IRS.  

Examples of how to treat expenses when doing taxes and using the cash method  

The IRS provides the following examples to illustrate how to handle expenses:  

  • Example of general rule: A calendar-year taxpayer pays $3,000 in 2021 for a business insurance policy that is effective for 3 years, starting July 2021. Under the general rule for business expenses (since the expense does not qualify for the 12-month rule), this cost is only deductible in the year to which applies. As a result, $500 is deductible in 2021 (6 months of the 36-month period are active in 2021), $1,000 is deductible in 2022 (12 months of the 36-month period), $1,000 is deductible in 2023 (12 more months of the 36-month period), and $500 is deductible in 2024.  
  • Example 12-month rule: A calendar-year taxpayer pays $10,000 for a one-year business insurance policy that is effective July 1, 2021. Since the 12-month rule applies to this expense, the full $10,000 is deductible in 2021.  

What is accrual basis accounting?  

The accrual accounting method is best suited for larger companies and records revenue and expenses when a service or good is provided, rather than when payment is made. Accrual accounting employs double-entry accounting and is required for companies with an average revenue totaling $25 million or more for three consecutive years. It is also GAAP-compliant since it provides the most accurate picture of your company’s finances.  

Using accrual accounting, if your company has provided a service for a customer but did not receive payment for it, you’d record two journal entries: a debit for accounts receivable and a credit for your revenue account.  

Many larger companies choose accrual accounting because it provides:  

  • Visibility of profits and revenues improves cash flow management  
  • Accurate snapshot of company finances at any point in time  
  • A clear picture of expected revenue so financial reporting is easier  

But accrual accounting can also be disadvantageous for smaller companies because it:  

  • Is more complex to set up and maintain than cash accounting  
  • Can make a company vulnerable to fraud if it doesn’t have internal controls  
  • Switching from cash basis accounting can be time-consuming and complex  

What is modified cash basis accounting?  

Some organizations use modified cash basis accounting, which records sales and expenses for long-term assets using an accrual basis, and transactions for short-term assets using the cash accounting basis. Using the modified cash basis method, companies can gain some clarity of accrual accounting without the time commitment required of a full switch to accrual accounting. Still, modified cash accounting does not comply with International Financial Reporting Standards (IFRS) or GAAP standards, which means that a modified cash basis isn’t adequate for a formal review of financial statements.  

To comply with GAAP and IFRS standards, a company must follow the consistency and matching principles of accounting. Since the modified cash basis inherently disallows inconsistency and matching, companies must convert transactions recorded on a cash basis to an accrual basis. Otherwise, financial statements cannot be properly cleared by an auditor. Companies with an average of less than $25 million for the last three consecutive years can choose between the cash or accrual accounting method.  

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