Finding solutions to accounting tasks helps you focus on your main business activities. As a small business owner, you may be able to use the cash-basis method for accounting. When is cash-basis accounting acceptable?
Before finding out if you can use cash-basis accounting, take a look at how this method works. Then, check out the list of businesses that can and cannot use cash-basis accounting near the end of this article.
What is cash-basis accounting?
Cash-basis accounting is a simple accounting method geared toward small business owners. If you run a small company, you may want to use the cash-basis method for your books.
To use the cash-basis method, you record each transaction as money changes hands. When you pay a vendor, you record the expense. When a customer pays you, you record the revenue.
Many sole proprietors and small partnerships prefer to use cash-basis accounting. There is a smaller learning curve than the accrual method and fewer items to record.
As your business grows, you might need to switch to accrual accounting. The larger your business is, the more revenue and expenses you have. A large volume of revenue and expenses might be easier to track with accrual accounting.
Accrual accounting is different from cash basis because you record transactions when you incur them. You record expenses when you receive an invoice, even if you have not yet paid it. You record revenue when you send an invoice, even if the customer has not yet paid you.
Benefits and disadvantages of cash-basis accounting
There are both benefits and disadvantages to using cash-basis accounting.
Cash-basis accounting is good for tracking cash flow. Cash flow measures the money coming in and going out of your business during a certain period. With cash-basis accounting, you can see how much actual cash you have at a given period.
But, cash-basis accounting is not ideal for matching revenue to an expense budget. When you close your books each month, your expenses should match your revenue. But, that is not always the case with cash-basis accounting.
For example, you may have trouble with cash-basis accounting if you buy products one month and sell them the next.You buy goods in April. You plan to pay the expenses of $2,000 from the goods with the revenue. But, you don’t sell the goods until next month. You sell the products for $3,000 in May.
When you close your books in April, your expenses are $2,000. Since you record transactions when you receive money, your books don’t show revenue in April. There is no revenue in the April books to offset expenses.
Your April books will show a $2,000 loss. And, your May books will show a profit of $3,000 when you record the revenue.
Your actual profit was $1,000 over both months, but cash-basis accounting makes it difficult to see.
Cash method of accounting for tax purposes
Using cash-basis accounting for tax purposes allows you to speed up expenses and slow down revenue in your books. You can do this by controlling the timing of your transactions. It’s possible to shift some of one year’s tax obligations over to the next year.
For example, you sell a product on December 20, 2015, but you don’t receive a payment until January 3, 2016. You report the expense for the current year (2015). You do not record the revenue until the next year (2016) because that’s when you receive payment.
When is cash-basis accounting acceptable?
Now you know about cash-basis accounting. But, when is cash-basis accounting acceptable?
The IRS regulates accounting methods to prevent falsely represented income on business tax returns. There are cash-basis accounting rules for which businesses can use the method.
Who uses cash-basis accounting?
Usually, the cash-basis method is for small, nonmanufacturing businesses. As you grow larger, the IRS expects you to switch to accrual. But if you match one of the types of business structures listed below, you can use cash-basis accounting:
- You are a C corporation or partnership with average gross receipts of less than $5,000,000 per year.
- You are a sole proprietorship or an S corporation with average gross receipts of less than $1,000,000 per year.
- You are not a publicly traded company and do not need to make many financial disclosures to the IRS.
- You are a personal service business and at least 95% of your business activities are related to the services you provide.
- You are a family-owned farm with average gross receipts of less than $25,000,000 per year.
When you can’t use cash-basis accounting
Some businesses are not allowed or unable to use the cash-basis method.
You can’t use cash-basis accounting if you sell products or services on credit. If you offer credit to customers for them to pay you at a later date, you must use accrual accounting. With cash-basis accounting, you do not record money due in the future.
The same concept applies to making purchases on credit. If your expenses are made on credit, you can’t use cash-basis accounting. With cash-basis accounting, you do not record expenses that you will pay in the future but have not yet paid.
The IRS restricts some businesses from using the cash-basis method. If you don’t meet any of the criteria listed under the “When you can use cash-basis accounting” section, you can’t use the cash-basis method.
You also can’t use cash-basis accounting if you report inventory on hand at the end of the year. Businesses with inventory must use the accrual method. Some exceptions are made for sole proprietors and very small businesses.
Are you ready to try cash-basis accounting? Patriot’s cloud-based small business accounting software uses a simple cash-in, cash-out system. You also receive free, U.S.-based support. Try it for free today.
This is not intended as legal advice; for more information, please click here.