Cash Basis Method of Accounting
Cash Basis Method
Many business owners ask if they should be cash or accrual when selecting the accounting method within their accounting package. Simply put, the accrual-basis method recognizes revenue when earned (not when paid) and recognizes expenses when obligated to pay (but not necessarily paid). Conversely, the cash-basis method recognizes revenue when cash is received and recognizes expenses when cash is paid (mailing a check on 12/31 or swiping your credit card on 12/31 is considered paid in the current year).
There is also a modified cash-basis method of accounting for those who have inventory where generally you using cash-basis for recording transactions but record all inventory transactions using accrual-basis. Which method should you use?
Yes, there are all kinds of exceptions, rules, thresholds, etc. and other nauseating details. Let’s skip those now. Most small businesses can operate just fine using the cash-basis method of accounting; cash comes in, revenue. Cash leaves, expense or distribution (or loan payment or capital expenditure). Easy. Cash-basis method also prevents phantom income or paying taxes on bad income. What do we mean?
If you send an invoice on 12/31 but the client never pays, and you forget this, you will pay taxes on phantom income. Or, you send an invoice for $10,000 on 12/31 but the client only pays $6,000 on 7/1 because of a negotiated write-down; you paid taxes on $10,000 and now you must wait until the following year to recognize the $4,000 bad debt and subsequent reduction in taxable income. $4,000 times your tax rate might not be a big deal; $40,000 times your tax rate might be a killer since you didn’t get the cash to pay the taxes.
Another scenario is where you invoice a client on 12/31 but because of norms in the industry, they don’t pay for six months. If this is a large invoice you will have fronted the taxes generated by it on April 15 but not get paid until July 1. That can really stink.
Cash-basis method of accounting takes the mystery out of this stuff.
One question we get all the time… literally all the time… “I built a website for this dude and he never paid me. Can I deduct the amount he owes me?” It depends. If you are cash-basis then No since you never recognized the income nor paid taxes on it. If you are accrual-basis where you invoiced the dude and recognized the income as taxable, then Yes. To recap, you can only deduct a bad debt if you previously recognized the income.
Here is another example to hopefully take this home. You are a landlord. Your property is vacant for two months; your rental income is naturally reduced by this vacancy and as such creates a built-in tax reduction (not deduction… reduction… with an r).
Keep in mind that over time accrual-basis and cash-basis converge for most small businesses. From year to year things might be different, but after 2-3 years historical net income between the accounting methods will start to converge. After a decade or more, historical net income is virtually identical between accrual and cash. Sure, there are probably extreme and rare examples where this statement fails, but generally speaking it holds.