Qualifying small businesses and service firms often use the cash-basis method of accounting. But as a business grows, it usually needs to convert to accrual-basis reporting for federal tax purposes and to conform with U.S. Generally Accepted Accounting Principles (GAAP). For federal tax purposes, the simpler cash method is generally available to small businesses with annual gross receipts of less than $5 million and to professional services firms of all sizes.
In recent years, Congress has threatened to require more businesses to make the cash-to-accrual conversion, so the IRS can collect taxes sooner. Here’s how these accounting methods differ and why it’s important to pick the reporting option that’s right for your business.
The difference between the cash and accrual methods is essentially a matter of timing. Companies that use the cash-basis method recognize revenue as customers pay invoices and expenses as they pay bills.
Conversely, the more complex accrual-basis method conforms to the matching principle under GAAP. That is, revenue (and expenses) are “matched” to the periods in which they’re earned (or incurred).
Balance sheet implications
Several asset and liability accounts are generally absent on a cash-basis balance sheet. Examples include prepaid expenses, accounts receivable, accounts payable, work in progress, accrued expenses and deferred taxes.
Cash-basis entities often report large fluctuations in profits from period to period, especially if they’re engaged in long-term projects. This can make it hard to benchmark the company’s performance from year to year — or against entities that use the accrual method.
Cash-basis entities also tend to postpone revenue recognition and accelerate expense payments at year end. This can make a company appear less profitable to lenders and investors. But the flipside is that this strategy temporarily defers the company’s tax liability.
Getting the IRS to approve a switch from cash to accrual reporting (or vice versa) requires some administrative legwork. We can help small businesses and service firms make the conversion for accounting and tax purposes. Moreover, we can help you adjust cash-basis financial statements to benchmark against other companies that use accrual-basis reporting methods.
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