It's Accrual Business

by Elaine Orgain

Every business must track transactions to measure its financial results. The method its owners choose to record this activity will determine how much they pay in taxes. It also reflects the value of their ownership in the business. For these reasons, it is wise to understand the difference between the following two methods of accounting before making that choice.

Cash-basis Accounting

What it is: recognizing only those transactions that affect your cash balance. This method recognizes business activity only when money changes hands (cash, checks, or bank debits/credits). A sale is a sale when the customer pays you, a purchase is an expense when you pay for goods, and income is the net change in your cash balance for any given period. This method produces only an income statement and is very simple to operate.

Who can use it: service businesses like gardeners, trainers, bookkeepers, etc., or professionals such as doctors and lawyers. Any business that does not carry inventory may elect to operate under cash-basis accounting. Its primary benefit is to delay the recognition of taxable income for future years so you can use that money now and pay it to the IRS later (hopefully, with inflated dollars).

What if your business is primarily a service but you also sell some related products to your customers? If those sales are “material to the business” in the eyes of the IRS, then you must use accrual accounting. Review your particular situation with a qualified professional and be aware that the IRS has the final say in this area. To be safe, use accrual accounting.

What to watch out for:

1. Incidental product sales may be classified as “inventory” by the IRS, requiring you to restate your results and recalculate the income tax due.
2. You will have to establish a separate method to track amounts customers owe you and amounts you owe to others.
3. Because it does not match revenues to expenses for the reporting period, cash-basis accounting is not a generally accepted accounting principle (GAAP), and GAAP compliance is typically required for bank loans and outside investors.

Accrual Accounting

What it is: recording every transaction “as it happens” whether or not cash is involved. This method records every business activity even though the events have not been consummated by the exchange of cash. This includes the recording of events based on the exchange of goods and promises made (purchase and sale agreements), as well as the simple passage of time (interest and depreciation calculations). Financial statements generated with this method include the income statement, balance sheet, and statement of cash flow.

When to use it: Any business may elect to use accrual accounting, but the IRS dictates that companies that carry inventory must use it. Without this requirement, a company could buy lots of inventory at the end of each year to reduce its income and pay less total tax. Accrual accounting is also the method sanctioned by generally accepted accounting principles.

What to watch out for:

1. Be careful to distinguish “income” from “cash” by understanding which transactions appear in the income statement and which show up on the statement of cash flow.
2. Establish periodic entries for “non-cash” transactions (i.e., interest, depreciation, amortization of prepaids, reclassification of deferred items, etc.).
3. Be clear about cut-off dates for the closing of each accounting period.

Implications of Your Choice

Selecting an accounting method: When setting up a new company, you must determine which accounting methods are available. If you will carry inventory, the answer is simple: You must use accrual-based accounting. Service companies have the option of cash or accrual methods and should examine their financial goals to see which method will produce the desired results (to minimize taxes or generate profits). Discuss this topic with your CPA or tax accountant before setting up your accounting system.

Changing your mind: The IRS allows companies using cash-basis accounting to switch to the accrual method because it will, most likely, generate higher income taxes. Once you are using the accrual method, however, you cannot switch to cash-based accounting. Companies that begin using the accrual method are not allowed the option to change, either.

Book vs. tax accounting: Companies that qualify for cash accounting can also elect to use the accrual method. They may also keep their books under both methods, using cash-based accounting for tax reporting and accrual accounting for reporting to investors, banks, and management. The option to change your tax accounting method from cash to accrual is still available but, once made, cannot be rescinded.

Resources for further study:

Nikolai , Loren A. and John D. Bazley. Intermediate Accounting. 9^th ed.Mason, OH: South-Western, div. of Thomson Learning, 2003. ISBN 0-324-18328-3

Recommended reading for the non-financial manager:

Mullis, Darrell and Judith Orloff. The Accounting Game.Naperville, IL: Educational Discoveries, Inc., 1998. ISBN 1-57071-396-0

Elaine Orgain is co-founder and CFO of New Business Consultants, Inc., and can be reached at 408-733-2663 or via email at elaine@newbizconsultants.com.