By Raffi Yousefian | Published 12/2/2020 03:04:52 PM
One of the most important steps in setting up a business’s accounting function is choosing an accounting method. The accounting method you select determines how you treat each transaction for bookkeeping, accounting, and reporting purposes.
It’s critical to pick one accounting method and stick with it to maintain consistency and comparability in your reporting. If you’re moving back and forth between methods, it’s impossible to analyze and understand your business’s finances.
However, it’s not as straightforward as selecting cash-basis or accrual-basis accounting and applying that method across the board. By asking some key questions about your business, you can:
- Apply a hybrid model of accounting that uses cash-basis accounting for some transactions and accrual-basis accounting for other transactions.
- Use a different accounting method on your tax returns vs. your financial statements.
So how would doing either of these things help your business? Let’s review our definitions of cash-basis and accrual-basis accounting to understand how these accounting method manipulations might make sense for your organization.
Differences Between Cash-basis vs. Accrual-basis Accounting
Cash-basis accounting recognizes revenue when it is received and expenses when they are paid, giving businesses an accurate picture of their current financial resources.
Accrual-basis accounting recognizes revenue as it is earned and expenses as they are incurred, providing better visibility into an organization’s performance.
Here’s the difference in cash-basis and accrual-basis accounting for one example:
In November, a software company receives $1,200 for a 1-year subscription and pays hosting fees of $200 per month for 12 months. In cash-basis accounting, the company would recognize $1,200 in revenue upon receiving payment in month 1, and $200 in expenses each month for 12 months. In accrual-basis accounting, the company would recognize $100 in revenue and $200 in expenses each month for 12 months. Accrual basis accounting provides a better representation of performance.
Cash-basis accounting is easy to understand, makes budgeting and tax returns simple, and is less costly and time-consuming to maintain. On the other hand, it doesn’t comply with Generally Accepted Accounting Principles (GAAP) in case of an audit, it renders the company unable to assess performance, and is generally not accepted by outside parties like banks, investors and lenders.
Accrual-basis accounting is compliant with GAAP, provides the visibility needed to get a true financial picture, and gives businesses the ability to perform financial modeling, statement analysis, and valuation of the company. However, it requires more expertise and time than cash-basis accounting (so it costs more), it is more difficult to understand, and it can complicate the tax preparation process.
How Hybrid Accounting Changes the Picture
There are clear pro’s and con’s to cash-basis and accrual-basis accounting. Taking a hybrid approach combines aspects of both which may provide a middle ground (accurate yet less costly) for understanding your organization’s financial health.
Under hybrid accounting, you choose which types of transactions are recorded using accrual-basis accounting and which are recorded using cash-basis accounting. Hybrid accounting makes sense as long as your choices provide a clear representation of income and expenses. Here’s an example:
A restaurant using hybrid accounting may choose to report sales on an accrual basis and food purchases on a cash basis. There may be a 2-3 day delay for cash from restaurant sales due to credit card processing. However, food purchases may be paid for the same day the food is used, assuming there are no vendor terms.
Using the hybrid approach, restaurant sales would be recognized on the day they are earned (accrual), rather than having a 2-3 day delay. Purchases would be recognized on the day they are paid for and used (cash). Reporting food purchases with the sales they relate to helps the restaurant have a profit & loss statement (P&L) that accurately reflects gross margins – assuming that the restaurant doesn’t keep any food inventory on hand.
When is Hybrid Accounting a Fit?
Hybrid accounting makes the most sense for businesses looking to close the gap between related financial inputs – like sales and food purchases. It’s a cost-effective way of gaining financial visibility, providing limited insight into performance, and offering the basis for financial modeling, statement analysis, and some KPIs.
However, hybrid accounting could actually create a bigger disconnect between revenue and related expenses. For the restaurant example mentioned above, maybe the restaurant doesn’t pay bills cash-on-delivery (COD). If they have vendor terms that either expedite or delay payment, reporting sales on an accrual basis and food purchases on a cash basis could widen the gap between the two. In this case, full accrual-basis accounting is the best way to accurately represent sales and food purchases.
Accounting Methods on Tax Returns
The accounting method an organization uses on its tax returns can be (and usually is) different from the accounting method used to prepare financial statements. Why? Tax returns and financial statements have different goals.
For tax return purposes, the goal is to choose the optimal accounting method that will allow the business to defer income, accelerate deductions, minimize tax exposure, and increase cash flow while clearly reflecting your income and expenses. The goal of a financial statement is to provide an accurate representation of a business’s financial performance.
Taxpayers can choose cash-basis, accrual-basis, or the hybrid accounting approach – provided that they use the same accounting method on their tax returns from year to year. There are some stipulations:
- If average gross receipts for the preceding three years exceeds $25M, accrual-basis accounting is required.
- If your business carries inventory, accrual-basis accounting is generally required, but there are some exceptions.
- If a single owner has multiple companies, each company can have a different accounting method. However, those related companies can only deduct business expenses and interest owed to a related party (maybe an investor or shareholder) in the tax year that the related party pays tax on that income. (In layman’s terms, this means that you can’t use the accounting method as a tool to shift income from one company to another with the intention of avoiding tax.)
But even with those stipulations, there are some exceptions to the rules. Qualified Personal Service Corporations, Partnerships without C Corporation partners, S corporations, and other pass-through entities are allowed to use cash-basis accounting regardless of the $25M gross receipts test – as long as this method is a clear reflection of income. Small business taxpayers, with less than $25M average in gross receipts for the 3 prior tax years, can choose not to keep inventory as long as their accounting method clearly reflects income.
Choosing an Accounting Method for Tax Returns
The accounting method you select for tax purposes should be the one that is most beneficial to your organization. It should clearly reflect income and expenses, and result in the highest deferment of taxable income – while staying in compliance with tax law. You’ll want to consider a number of variables when making your choice. Here are some key questions to answer:
Are your business’s financial statements using cash-basis or accrual-basis accounting (with inventory)?
If your organization has inventory recorded on its books, accrual-basis accounting is generally required. If cash-basis is used on financial statements, use cash-basis accounting for tax returns.
Is Accounts Receivable (A/R) usually in excess of Accounts Payable (A/P) on your books?
If the answer is yes, cash-basis for tax purposes makes the most sense. That way the taxpayer is not subject to tax on revenue they have not received yet.
If the answer is no, it’s important to perform an accrual-to-cash conversion. This comparison will help determine where revenue is higher – with cash-basis accounting or accrual-basis accounting. You’ll want to choose the method that defers the most taxable income.
Do you use other accrual accounts such as prepaid expenses, accrued expenses, or deferred liabilities?
If the answer is yes, you’ll also want to perform an accrual-to-cash conversion to determine which accounting method provides the highest deferment of taxable income.
Do you have zero A/R but high A/P, or high deferred revenue?
If the answer is yes, you’ll want to choose the accrual-basis method of accounting. This is a likely scenario for Software-as-a-Service (SaaS) or other subscription-based business models, where revenue is collected monthly or annually – resulting in zero A/R. At the same time, there are accrued salaries and A/P at the end of the year.
Determining Accounting Methods Can Be Challenging
When evaluating accounting methods, you’re not just choosing between cash-basis and accrual-basis accounting for your organization. Instead of selecting one or the other, you can take a hybrid approach – if it fits your financial landscape. You can select one method for tax returns and another for financial statements. And if you change your mind, you can change accounting methods – but that requires some careful planning.
If you’re struggling to make a choice, a firm like RY CPAs can help. Our accounting experts can walk through your specific circumstances and make an informed recommendation that will accurately represent your financials and defer the most taxable income.
Contact our team of experts for a discovery call to learn more.