Cash vs. Accrual Accounting for Taxes – Which One Should You Choose?
In our previous article, we looked at the difference between cash and accrual accounting from a bookkeeping perspective. But for any business, there comes a time where taxes have to be paid.
And what accounting method you choose has significant implications for your tax strategy. That’s why it's important you think about it carefully!
In this article, we examine the difference between cash and accrual accounting from a tax perspective. We’ll discuss the key features, pros, and cons of each.
Let’s get started.
What Is Cash Accounting?
Cash accounting, or cash basis accounting, means that income and expenses are recognized only when cash is received or paid. So, if you get paid today for a project that you will be completing next year, you record the revenue as if it happened today. And if you get paid next year for something you’re doing today, the revenue is recorded as if it happened next year.
Under cash accounting, revenue is recorded when payment is actually received, and expenses are recorded when they are paid. This has an impact on when you are paying taxes.
Pros
Legal tax deferral – You can delay recognizing income until cash is received, deferring tax liabilities.
Simple – It's straightforward and easy to implement, making it a good option for small businesses and sole proprietors.
Cons
Limited to smaller businesses – The IRS only allows businesses that do under $25 million a year in average annual gross receipts.
Can give a misleading view of your business – May not accurately reflect the financial health of a business, as it doesn't account for outstanding receivables or payables.
What Is Accrual Accounting?
Accrual accounting for tax purposes means recognizing income and expenses when they are earned or incurred, regardless of when cash is paid or received. So, if you get paid today for a project that you will be completing next year, the revenue is recorded as if it happened next year. And if you get paid next year for a project that you complete today, the revenue is recorded as if it is happening today.
Under accrual accounting, revenue is recorded when earned, and expenses are recorded when incurred. This approach adheres to the matching principle, which can be beneficial for tax planning. Accrual accounting is also the required accounting method for businesses that do over $25 million in average annual gross receipts.
Pros
Accurate financial picture – Gives a clearer view of long-term profitability and financial performance.
Alignment with GAAP – Required for larger businesses and aligns with Generally Accepted Accounting Principles (GAAP).
Cons
Complexity – More complex to do than cash accounting.
Potential cash flow challenges – A business can appear profitable on paper but still face cash flow issues, which can affect tax payments.
Immediate tax liabilities – Income is recognized when earned, which may lead to immediate tax liabilities even if you haven’t received the cash yet.
What Are the Differences?
| Cash Accounting | Accrual Accounting | |
|---|---|---|
| Timing of income recognition | Recognized when cash is received | Recognized when earned, regardless of when payment is received |
| Timing of expense recognition | Recognized when paid | Recognized when incurred, regardless of when payment is made |
| Timing of taxes | Can defer income recognition to next tax year if payment is received later | Must report income in the year it's earned, even if payment is received later |
| Legal limitations | Generally limited to businesses with less than $25 million in average annual gross receipts | Required for larger businesses (over $25 million in average annual gross receipts) |
| Tax planning flexibility | More control over timing of income and expenses for tax purposes | Less flexibility in timing income and expenses for tax purposes |
| Compliance with GAAP | Does not comply with GAAP | Complies with GAAP |
| Complexity | Simpler to implement and maintain | More complex, requires more sophisticated accounting |
| IRS Preference | Acceptable for many small businesses | Required for larger businesses and certain industries |
Which One Should You Choose?
There is no clear answer to that question, because it’s really a case-by-case type thing. While there are general guidelines, it's important to consider your unique situation.
If your business has average annual gross receipts exceeding $25 million, the choice is straightforward – you're required to use the accrual method for tax purposes. This requirement makes sure that larger businesses provide a more accurate representation of their financial position to the IRS.
For businesses under the $25 million threshold, the decision is more nuanced:
If you anticipate your business growing beyond $25 million in gross receipts in the near future, it might be smart to start using the accrual method now. This can save you the hassle of changing methods later and keep your financial reporting consistent.
For small businesses that don’t necessarily have plans of growing beyond $25 million and just want to keep it simple, cash accounting might be the right decision. It's easier to implement and maintain, which can be handy if you're handling your own taxes or have simple financial transactions.
Consider your industry and business model. Some industries naturally align better with one method over the other. For instance, ecommerce businesses with large inventory might benefit from accrual accounting, even if they're below the $25 million threshold.
When it comes to taxes, each method has different implications:
Cash basis accounting can offer tax advantages for some businesses. It allows you to delay recognizing income until payment is received, potentially reducing your taxable income in a given year. This can be particularly beneficial if you expect your tax rate to be lower in the future.
Accrual accounting, while potentially more complex, can provide a more accurate picture of your business's financial health. From a tax perspective, this makes sure that income and expenses are matched in the appropriate tax year, which can be important for businesses with long-term contracts or significant accounts receivable.
The timing of income recognition and expense deductions differs between the two methods, which can significantly impact your tax liability. For instance, under the cash method, you might be able to accelerate expenses by paying them before year-end, thus reducing your taxable income for the current year.
If your business carries inventory, the tax implications become more complex. The IRS has specific rules about when you must use accrual accounting for inventory, even if you're below the $25 million threshold.
It's entirely possible – and sometimes even beneficial – to use different methods for bookkeeping and tax purposes. For instance, you might use accrual accounting for your day-to-day bookkeeping to get a clearer picture of your financial health, while using cash accounting for tax purposes to take advantage of potential tax benefits.
If you're not sure which method is best for your business's taxes, we can help you out! Tax laws can be complex, and this seemingly simple decision can have significant implications for your business's financial health and tax liabilities.
If you want our thoughts on your unique situation, feel free to schedule a no-obligation, 30-minute consultation here.
Key Takeaways
Cash accounting recognizes income and expenses when cash is received or paid, potentially deferring tax liabilities.
Accrual accounting recognizes income and expenses when earned or incurred, regardless of when cash changes hands.
Businesses with over $25 million in average annual gross receipts must use accrual accounting for tax purposes.
Smaller businesses can choose between cash or accrual, depending on their specific needs and growth plans.
It's possible to use different methods for bookkeeping and tax purposes if it benefits your business.
