Are you paying taxes on money before you should? Read on to find out whether an accounting method change is needed for your small business.
What Does “Accounting Method” Even Mean?
Per the IRS, an accounting method is a set of rules used to determine when and how a taxpayer takes income and expenses into account on their tax return.
Different methods exist thanks to the US tax code. It recognizes businesses come in many shapes and sizes and allows flexibility in determining how you’re taxed.
Cash Vs. Accrual Methods
The two most common methods are cash and accrual.
The cash method requires you to match your cash in with your cash out. Revenue is the cash received that year, while expenses are the cash spent.
Small businesses with average annual gross receipts less than $25 million for the past three years can use this method.
The major benefit of the cash method is simple: cash. The tax you owe will be based on money you actually received. Any tax troubles are likely due to poor planning, since you had the money at one point.
However, a business with high accounts payable and low accounts receivable may prefer the accrual method. Expenses owed but not paid result in higher net income and tax on the cash method.
The accrual method requires you to match when income and expenses are earned and incurred, not necessarily received or paid. Revenue is the cash and accounts receivable earned that year, while expenses are the cash and accounts payable incurred that year.
Small businesses with average annual gross receipts greater than $25 million for the past three years are required to use this method, as are businesses that keep an inventory, unless they meet the small business exception.
The major benefit is timing. Businesses using the accrual method don’t see large tax fluctuations year over year because income and expenses are matched when earned.
For example, a business that buys inventory at the end of the year wouldn’t be able to deduct any of those expenses until they sold those items the following year. As a result, they would offset next year’s income with the cost of the inventory sold, even though they purchased it in the prior year.
However, a business with high accounts receivable and low accounts payable may prefer the cash method. Income earned but not received result in higher net income and tax on the accrual method. They may not have received enough cash to pay those taxes either.
If you’d like to read more, check out IRS Publication 538: Accounting Periods and Methods.
Working With Haworth & Company, Ltd.
As you can see, choosing the right accounting method is a big deal. If you need help deciding which is best for you, or just realized you’ve been filing under the wrong method for years, check out our accounting or consulting services and give us a call! We’ve helped many businesses in Minnesota change their accounting method and would love to see you immediately benefit too.