Accounting is a practice and an art.
Accounting is a practice since a particular accounting method can be employed to report your company’s financial position to make decisions that best suit your tax liability, communicate your business’ value, and evaluate long-term goals. Accounting is an art because your business and your finances are unlike any other businesses – your company is one of a kind.
The most commonly used accounting methods for small business are accrual basis and modified cash basis. This article will compare cash basis, accrual basis and modified cash basis.
This reflects revenue as it is earned and expenses as they are incurred irrespective of whether received or paid. Any transaction will have an entry in two different accounts – Income statement accounts (revenue and expense) and Balance sheet accounts (assets, liability, equity). Accrual accounting is better illustrates profitability, performance, trends, cycles, forecasting, and budgeting. It is used to better predict future income and expenses, anticipate long-term profitability, and create realistic and achievable financial goals.
To illustrate, let’s use a simple example of a sale and the related receivable. Your business sells and ships your widgets to a customer with an invoice for $10,000 with payment terms of Net 30.
On December 1st. Accounts Receivable will be debited $10,000 and Sales Revenue will be credited $10,000.
On December 20, your customer pays your invoice in full. Cash will be debited $10,000 and Accounts Receivable will be credited $10,000.
This accounting system has a built-in verification system. If information is not entered correctly, the trial balance will show that total sums of debits and credits will not be the same. The accrual method of accounting accurately shows whether a customer’s invoice for a project is still open or if payment was made is full. This system will report expenses and revenues in the same period whereby eliminating overstatement of profits. Since this method conforms to GAAP (Generally Accepted Accounting Principles), this is important in producing financial statements for loans, investors or other third parties.
There are few downsides in an accrual system. It is more complex, so it does require more time and expertise to implement and maintain for accurate reporting.
Modified Cash Basis Accounting
Tracks cash flow and long term finances. The key to this method is you must be consistent in order to have comparable numbers over time. Income and expenses need to be inputted as a primary cash basis method.
If you use the cash method for income, then expenses must be reported using the cash method. If you use the accrual method to report income, then expenses must be recorded using the accrual method. If you have inventory you must use accrual and report sales and purchases using accrual. All other transactions can be either cash or accrual.
Here is an example:
Regular monthly expenses such as utilities are recorded using the cash method. Long-term items (longer than 1 year) like a loan or an investment will be recorded using accrual.
Applying the modified cash basis may be acceptable as long as there is no need for the financial statements to be compliant with GAAP; this may be the case if the financial statements are only to be used internally. This situation most commonly arises when a business is privately held and has no need for financing.
Change Your Accounting Method
When you initially establish your business it isn’t necessary to request permission from the IRS to declare your chosen accounting method. You can select the method as you wish on the first business tax form filing of your entity’s existence. However, in later years, should there be a need to change, you will need to file Form 3115 with the IRS to request permission to use another method.
Once your annual gross receipts equal or exceeds an average of $25 million over three years, you are required to file annual tax returns as an accrual basis taxpayer. There are a few exceptions to this rule. However, there could be reasons why you might be better to elect accrual basis filing at the start. Restaurants are an example where it may be beneficial to elect an accrual basis for tax purposes rather than cash.
The (modified) cash basis method of filing is usually the ideal method for most new businesses and small businesses. The reason for this is that tax is calculated only on revenue you have physically received less expenses paid.
When deciding which accounting method is best for you consider: business size, accounting laws to follow, anticipated growth, types and volume of transactions, detail of your general ledger. If you need help setting up or changing your accounting method please contact us to be your partner in this crucial decision.