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Accrual versus cash accounting is something every business should make a decision on before tax returns are filed. Here’s an explanation of each so you can decide which works best for your business.
What is Accrual Accounting?
Accrual accounting is when you count an income or expense at the time of billing, regardless of when cash actually exchanges hands. So if you finish up a project and send a final invoice to your client in September, you count that as income for September, even if the client doesn’t pay you until December.
Any business can use accrual accounting as the method for declaring income and expenses.
What is Cash Accounting?
Cash accounting is when you count an income or expense at the time when cash exchanges hands. So you sent a client an invoice three months ago, but they just paid it today, so you count it as income today even though the project was completed several months back.
Only businesses that have sales totaling less than $25 million can use cash accounting.
Should I use Accrual or Cash Accounting?
Cash accounting is popular because it’s very easy to track. You could quickly look at your bank account to confirm when the payment came through if you think there was a mistake.
If you are a small business and just starting out, the cash accounting method would make it easier for you to handle your taxes by yourself since you can sync your business bank account with something like QuickBooks Online, and easily file your taxes at the end of the year.
Accrual accounting is the more commonly used method for tracking income and expenses for taxes. With accrual accounting, you can easily monitor your business growth. If you sent out 1 invoice per month in a year, and all 12 invoices were paid off in December, the cash accounting method would make it look like December was your busiest month, even though your business had stable income throughout the year. For this reason, most companies prefer to use the accrual method.
Another perk of accrual accounting is that you can send out invoices to clients at the end of one year, or the beginning of the next, depending on which helps reduce your taxes more. Keep in mind that you only get to decide which method to use if you bring in less than $25 million per year. If you make more, you are required to use the accrual method.
Can I Switch from Cash Accounting to Accrual Accounting?
Absolutely! If you started with one method but decide later on that the other method might work better for your business, you can change your accounting method by filing Form 3115 with the IRS.