Is the Cash or Accrual Method of Accounting Right for Your Business?
June 15, 2021 - Cash is king for most – if not all – companies, and the ability to defer income taxes frees up cash and makes it available for reinvestment in the business. Moreover, maintaining a healthy reserve can sometimes mean the difference between surviving and thriving. So why pay the government early?
In answering the cash vs. accrual accounting question, keep in mind that the accounting approach you leverage should meet your unique needs for liquidity. Understanding the cash and accrual accounting methods, especially for tax purposes, can help you make a more informed decision – and ultimately impact the growth of your business.
The Difference Between Cash and Accrual Accounting Methods
The difference between the cash and accrual methods of accounting is rather simple and has everything to do with the timing of sales and purchases – and when they are recorded in a company’s accounts.
In the cash method, the company would report income in the year actually (constructively) received and deduct (capitalize) expenses in the year paid. Generally, you can do this if inventory is not an income-producing factor, or if its role is small compared to the services provided.
Under the accrual method, a company would report income in the year earned and deduct expenses in the year incurred. This method is required when you maintain inventory for production, purchase, or sale unless you meet an exception.
The cash method of accounting would most likely be the preferred method of accounting for many businesses. For example, let's say a company's accounts receivable is greater than accounts payable (accrued expenses). The cash method grants them the ability to defer paying income taxes on the difference. It takes cash flow into consideration, allowing a company to pay tax on income when received, instead of when earned.
However, there are certain factors that determine eligibility for the cash method, and some companies may not qualify.
Determining Factors for Utilizing the Cash Method
Many companies qualify for the cash method because of their business’s unique characteristics. Factors that determine whether to use cash or accrual-based accounting include:
- What a company produces or provides as a service,
- How they’re organized (entity type and organizational structure), and
- Gross revenues a company has received
Unless an exception applies, the following cannot use the cash receipts method of accounting:
- C corporations,
- Partnerships with a C corporation as a partner, or
- Tax shelters
What about exceptions? Here are some exceptions you may leverage to avoid having to use the accrual method:
- Gross receipts test
Non-tax-sheltered businesses with average annual gross receipts of $25 million (adjusted for inflation to $26 million for 2020 and 2021) or less over the past three years usually qualify for the cash method. The gross receipts amount is indexed for inflation in multiples of $1 million.
- Qualified personal service corporations
Non-tax-sheltered businesses in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting can usually use the cash method of accounting. Substantially all the stock must be held directly or indirectly (through another entity) by employees performing services for such corporation in connection with the services listed above.
- Farming business defined under section 263A(e)(4) or 263A(e)(5) of the Internal Revenue Code
The term tax shelter includes: 1) the sale of regulated securities, 2) any syndicate, and 3) an entity where the purpose of such entity is the avoidance of tax. A syndicate means an entity (other than a C corporation) if more than 35 percent of the losses of such entity during the taxable year are allocable to limited partners or limited entrepreneurs. A limited entrepreneur is any person who has an interest in an enterprise other than as a limited partner, and does not actively participate in the management of such enterprise.
Review Your Method Annually
The longer a company can defer paying income taxes, the more cash they will have on hand to inject into the business and potentially leverage for future growth. However, not every company will qualify for using the cash method of accounting – or may lose their eligibility to do so as their business changes.
Companies can also elect to maintain their books using the accrual method of accounting and use the cash method for tax purposes. The accrual method is often required by banks, as it can help companies verify their financial position.
In any case, every business should review their situation each year to ensure that they are using the method that best supports the unique characteristics and goals of their business.
Jared Weiskopf, CPA
Jared Weiskopf is a partner in the business tax service area and is the state and local taxation service area leader. He assists clients with corporate and partnership tax preparation, tax planning and research, and works with a variety of clients in industries such as manufacturing and professional services. Jared has provided public accounting services at Redpath and Company since 1997.
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