Business owners like you should not only be hardworking and motivated. They must also be clever. From sourcing the cheapest materials to finding the cheapest labor without compromising the quality of their items; entrepreneurs have many ways of displaying their shrewdness. Being shrewd can give them the edge over their competitors.
Managing the company’s finances is one area where business owners should be very clever. In particular, being familiar with the principal methods of keeping track of income and expenses—cash and accrual—would enable business owners to know which method of account is best for their business.
And it’s simply not for complying with tax rules and regulations. Sometimes, being familiar with accounting nitty-gritty can save a business owner thousands of dollars for a fiscal year.
Take, for instance, delaying taxes on a portion of their income for a year. There’s a very generous accounting rule that allows an entrepreneur or a company to delay paying taxes on a fiscal year.
So say that you are a business owner, and the IRS would let you take a year to pay taxes on an income amounting to $11,000. You’ll have 12 months to produce $2,750 assuming that you have a tax rate of 25%. You could instead defer paying that tax and use the money to invest in advertising. Or maybe upgrade your equipment so that your business becomes more productive and profitable.
To better illustrate how the accrual method of accounting can benefit business owners by letting them defer payment of a portion of their income tax, let’s look at the two methods of recording accounting transactions.
In the cash method, the income is counted when your company receives money or check. Expense is counted when your firm pays for a service or product.
Let’s cite an example so you can better understand. If you sell merchandise amounting to $500 to a customer in January and receive payment for it on March 1, you can record the income on March 1. This is because it was only on March 1 that you received the payment.
This method is preferred and practiced by more small business owners. For one, it is easier to maintain. Business owners or their bookkeepers only record when the firm receives cash or pays cash out. It is straightforward and simple. It requires little record-keeping other than checkbook register and bank statements.
But one disadvantage of this method is that it can distort the picture of your firm’s income and expenses. It won’t account well for situations wherein you have used credit to buy supplies or extend credit to your customers.
It can also lead you to falsely believe that your business is experiencing highs and lows. For instance, if your company receives many payments for a month, you may think that the business is booming. But the reality could be that those payments came from sales that took place many months earlier.
On the accrual basis, transactions are only counted when they happen. It doesn’t take into account the date the money is actually received or paid. There’s no need for you to wait until you see the customer’s money being transferred into your account, or you actually pay out of your checking account if we talk about expenses.
In the accrual method of accounting, the job completion date is the one that matters. You can’t put the income down in your books until your business finishes a service or delivers all the products as specified in the contract. So if a job takes another 30 days for the finishing touches, it doesn’t have to go on the books until the 30 day period has lapsed.
For example, your business is a leather repair shop. It has been commissioned to repair an antique leather couch, with the job completed on December 10, 2015. Your business bills the customer for $1,000, which you receive on January 10, 2016. In the accrual method of accounting, your business will have to record that income in December 2016 even though your firm has yet to receive payment from the client.
The foundation for accrual accounting is the “matching principle.” This is the idea that expenses must be recorded whenever an obligation is incurred. When a firm makes a sale, the expenses needed to produce the item or provide the service must also be recorded in the same period—regardless of when the cash is paid.
The strength of the accrual method is that it can tell you the health of your business. You would know if the company is booming or slowing down, depending on the number of orders or deliveries that it is posting for a certain period.
But it won’t tell you what cash your business has on hand. This, in turn, could lead you to add debt that you can’t afford. Moreover, the accrual basis is very complicated for most small business owners. Shifting tax burdens using this method is also difficult for most entrepreneurs.
Some small businesses try to get the best of both worlds, so to speak, by using a hybrid method. They use the cash method for income and expenses, and accrual basis for inventory as required by the IRS.
Certain types of businesses are also allowed to use special accounting methods, like builders, contractors, farmers, and business owners who receive payments under long-term contracts.
While the accrual method can be complex for most business owners, it can be very useful for those who want to save on taxes. As mentioned earlier, large businesses use this type of accounting. Even small businesses with sales under $5 million a year can use accrual accounting. With the accrual method of accounting, business owners can reduce their tax burden or liability.
In the accrual method, businesses can delay recognition of an income to a future tax year to reduce their tax liability for the current year. This explains what we mentioned earlier—that if a business has an income amounting to $11,000 for year 1, it can elect to defer payment of $2,750 in taxes for the said income to the next succeeding year.
To better illustrate how accrual accounting can work to the advantage of small businesses in deferring tax payment, let’s cite a few examples.
Usually, businesses include advance payments for the services in the tax year that they receive them. But they can also choose to declare that payment until the next year until the product or service has been completed.
For example, a contracting firm uses the accrual method of accounting. It receives a $100,000 advance payment in December 2016 from a client for the construction of a house to be completed by the end of 2017. The firm has the option not to include the amount in its income for tax purposes for 2016, but instead declare it for 2017.
The game goes for advance payments for goods and properties. Businesses can postpone reporting income from the advance payments they receive from properties they sell, lease, build, or install.
For example, a magazine receives a 12-month subscription for its monthly publication. In November 2016, it received a payment of $120 from a subscriber who agrees to pay the entire cost upfront. The said firm can postpone reporting the income until the completion of the contract, or when it has completed delivering the magazines to the subscriber.
In these scenarios, the companies can opt to use the payments they received to grow their businesses, like investing or buying new equipment.
However, companies who opt for accrual accounting have to follow certain rules if they want to defer recognizing income during a certain year.
Generally, businesses are not allowed to defer the inclusion of advance payment in income for services that they are to perform after the end of the tax year following the year that they received the payment.
To further illustrate this, a dance studio gets a two-year contract for 96 one-hour dance lessons. It received an advance payment for the contract in October 2016. The contract would stretch up to 2018. The company is thus obligated to recognize the payment in its 2016 income because part of the services won’t be performed until 2018 (or the year after the year it received the payment).
Deferring reporting income is also not allowed if the company receives it under a guarantee or warranty contract. The same goes for income from prepaid rent.
Aside from the flexibility that accrual accounting can afford to small business owners, there are other advantages or benefits that this accounting method can give to entrepreneurs.
One is that it gives a better picture of a company’s financial performance. Accrual accounting allows the business owner to easily see how the company is doing as far as finances are concerned. He or she will be able to see where the profits are coming from, and where the expenses are going.
Another benefit of accrual accounting is that a business owner would be able to track historical trends. Since accrual accounting can track revenue and expenses, it allows for a better way of tracking business activities. Business owners will be able to identify trends that are related to occurrences in the market place.
Accrual accounting can also benefit the company by making access to credit easier. Since companies will be able to keep track of their financial performance with accrual accounting, they stand a better chance of getting access to credit from financial institutions. This is particularly important for small businesses that need credit to expand, and at times, to survive.
Finally, accrual accounting would enable firms with annual sales of $5 million or annual inventory sales of $1 million to meet generally accepted accounting principles or GAAP. The latter is considered the industry standard for financial statement preparation. Meeting GAAP enables investors and financial institutions to easily determine a company’s financial health or standing.
Now that we have established that accrual accounting can enable a small business to defer paying of taxes under certain conditions, the next question you may have in mind is how to change from cash to accrual accounting.
Changing the accounting method should be approved by the IRS first. To do this, you should file Form 3115 or Application for Change in Accounting Method. You’ll have to pay a user fee for this.
You can also contact a business or commercial law attorney, or inform your accountant, about your desire to shift from cash to accrual accounting. These pros can help your business change to the accounting method that can increase your business’s profitability and shield it from taxes during certain tax years.
The accrual method of accounting may be something you aren’t familiar with as a business owner. You may have been accustomed to the cash-basis that you can’t imagine shifting your accounting methodology anytime soon.
But as you have realized upon reading this article, the accrual method of accounting can give you a lot of benefits. It can enable you to defer payment of taxes for a particular year. The money that could have been spent on tax payment can then be used by the business for initiatives like buying equipment and even investments.
As a business owner, it only makes sense for you to study the nitty-gritty and even shift to the accrual method of accounting from a cash-basis method. While it is complicated and time-consuming, it can be very advantageous to your business. Aside from the tax savings, you can get, accrual accounting can enable your business to grow. You would be able to study better the financial health of your business and get access to loans from financial institutions.