Cash or Accrual…Why Does It Matter to Me?
Jasmine is setting up her salon business and has been asked whether she will use the cash or accrual accounting method. These terms are foreign to her because she went to cosmetology school, not business school. She needs to decide which method she will use to move forward with her plans and has asked for my help.
The two most known, and basic, methods of accounting are cash and accrual. Whichever, method is used, it must remain consistent or permission from the IRS must be granted to change. Most small businesses prefer to use the cash method, because it seems much simpler, but Generally Accepted Accounting Principles would like for more businesses to use the accrual method. This is because matching the revenue with expenses is much easier to do and gives the business owner a better picture of how they are doing financially.
Jasmine is interested in using the cash method because it seems easier to manage. She would report her revenue when she receives it and her expenses will be recorded when she pays for the items. Putting off the recording of income to when it is received can also be beneficial for Jasmine’s cash flow. When tax time rolls around, she will only pay taxes on the money she received.
However, if Jasmine plans on selling any type of products in her salon, she will need to use the accrual method of accounting. Since a salon collects income when services are performed, reporting the revenue when it is received will not be any different between the cash and accrual methods. The difference is when expenses are recorded.
There are two rules as to when an expense will be recorded. Per the IRS, Publication 535, “All events have occurred that fix the fact of liability”, “The liability can be determined with reasonable accuracy” and “Economic performance has occurred”.
Jasmine has placed an order for hair products and received the items in October but does not need to pay the invoice until November. She will record the bill in October because she is liable for the payment, the liability (cost) is known and she has received the inventory (economic performance). This will be reflected in the expense portion of the general ledger. The payment will show in November when the check is processed and sent to the vendor.
During November, Jasmine had some repair work completed and she did not receive the bill until the last week of December and she paid the company in January. Since she had received the services, she was responsible for the liability and she knew the amount, she could record the expense in December and use that expense as a deduction on her taxes, even though she did not actually pay the bill until the following year.
Since this seems like a great way to get some added deductions, Jasmine asks if she can prepay her rent and insurance. Although this seems like it might be a great way to reduce her tax liability, the answer is NO! Expenses that are for an entire year need to be entered in a prepaid category and then a journal entry needs to be done every month to increase expenses and decrease the prepaid account.
There is an exception to the accrual method! If Jasmine owes money to her sister (any relation per IRS) Maria for a business transaction and Maria uses the cash method of accounting, Jasmine cannot take the deduction until the amount is paid. This is one area that the rule of deducting expenses when they are incurred does not apply.
The accrual method takes a little more knowledge about how to handle the reporting of expenses but finding a trusted CPA should help with that. If you have any questions, please contact us at firstname.lastname@example.org or 407-988-5647.
Categories: General Business