Accounting methods refer to the basic rules and guidelines under which businesses keep their financial records and prepare their financial reports. There are two main accounting methods used for record-keeping: the cash basis and the accrual basis. Small business owners must decide which method to use depending on the legal form of the business, its sales volume, whether it extends credit to customers, whether it maintains an inventory, and the tax requirements set forth by the Internal Revenue Service (IRS). Some form of record-keeping is required by law and for tax purposes, but the resulting information can also be useful to managers in assessing the company's financial situation and making decisions. It is possible to change accounting methods later, but the process can be complicated. Therefore it is important for small business owners to decide which method to use up front based on what will be most suitable for their particular business.
Accounting records prepared using the cash basis recognize income and expenses according to real-time cash flow. Income is recorded upon receipt of funds, rather than based upon when it is actually earned; expenses are recorded as they are paid, rather than as they are actually incurred. Under this accounting method, therefore, it is possible to defer taxable income by delaying billing so that payment is not received in the current year. Likewise, it is possible to accelerate expenses by paying them as soon as the bills are received, in advance of the due date.
A company using an accrual basis for accounting recognizes both income and expenses at the time they are earned or incurred, regardless of when cash associated with those transactions changes hands. Under this system, revenue is recorded when it is earned rather than when payment is received; expenses are recorded when they are incurred rather than when payment is made.
As we've seen, the key difference between the two methods of accounting has to do with how each method records cash coming into and going out of the company. At any one point in time, a company's accounts will look very different depending on which accounting method was used to prepare those accounts. Over time, these differences diminish since all expenses and revenues are eventually recorded.
If a company called, say, Cash Method Company, pays its annual rent of $12,000 in January, rather than paying $1,000 per month all year, it will show a rent expense of $12,000 in January and no rent expense for the rest of the year. If another organization, Accrual Method Company, made the same rental payment in January, its records would show a $1,000 rent expense in January as well as in each month of the year. At the end of the year, the expense records of the two companies will look very similar. At any point earlier in the year, however, the two company records will look very different.
The cash method offers several advantages: it is simpler than the accrual method; it provides a more accurate picture of cash flow; and income is not subject to taxation until the money is actually received. A disadvantage of the cash method is that expenses and revenues are not matched in time. For example, if a company provides landscaping services to a client in early April, it will likely send that client an invoice in May and may not receive payment for the services provided until June. Meanwhile, employees will be paid for the time they spent on the project in April and May. Accordingly, the accounting records will show high expenses in April and May with no corresponding income.
In contrast, the accrual method is designed to recognize income and expenses in the period to which they apply, regardless of whether or not money has changed hands. Under the accrual basis of accounting, the income associated with the landscaping services described above would be recorded in April, the month in which the services were provided, even though the payment for those services may not arrive until June. Consequently, the company using an accrual method of accounting will have records that show expenses and revenues for the landscaping job in the same month. The main advantage of the accrual method is that it provides a more accurate picture of how a business is performing over the long-term than the cash method. The main disadvantages are that it is more complex than the cash basis and that income taxes may be owed on revenue before payment is actually received.
Under generally accepted accounting principles (GAAP), the accrual basis of accounting is required for all businesses that handle inventory, from small retailers to large manufacturers. It is also required for corporations and partnerships that have gross sales over $5 million per year, although there are exceptions for farming businesses and qualified personal service corporations—such as doctors, lawyers, accountants, and consultants. A business that chooses to use the accrual basis must use it consistently for all financial reporting and for credit purposes. For anyone who runs two or more businesses, however, it is permissible to use different accounting methods for each.
In some cases, businesses find it desirable to change from one accounting method to another. Changing accounting methods requires formal approval of the IRS, but new guidelines adopted in 1997 make the procedure much easier for businesses. A company wanting to make a change must file Form 3115 in duplicate and pay a fee. A copy should be attached to the taxpayer's income tax return and the other copy must be sent to the IRS.
Any company that is not currently under examination by the IRS is permitted to file for approval to make a change. Applications can be made at any time during the tax year, but the IRS recommends filing as early as possible. Taxpayers are granted automatic six-month extensions provided they file income taxes on time for the year in which the change is requested. The amended tax returns using the new accounting method must also be filed within the six-month extension period. In considering whether to approve a request for a change in accounting methods, the IRS looks at whether the new method will accurately reflect income and whether it will create or shift profits and losses between businesses.
Changes in accounting methods generally result in adjustments to taxable income, either positive or negative. For example, say a business wants to change from the cash basis to the accrual basis. It has accounts receivable (income earned but not yet received, so not recognized under the cash basis) of $15,000, and accounts payable (expenses incurred but not paid, so not recognized under the cash basis) of $20,000. Thus the change in accounting method would require a negative adjustment to income of $5,000. It is important to note that changing accounting methods does not permanently change the business's long-term taxable income, but only changes the way that income is recognized over time.
If the total amount of the change is less than $25,000, the business can elect to make the entire adjustment during the year of change. Otherwise, the IRS permits the adjustment to be spread out over four tax years. Obviously, most businesses would find it preferable for tax purposes to make a negative adjustment in the current year and spread a positive adjustment over subsequent years. If the accounting change is required by the IRS because the method originally chosen did not clearly reflect income, however, the business must make the resulting adjustment during the current tax year. This provides businesses with an incentive to change accounting methods on their own if they realize that there is a problem.
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