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Deciding Between the Cash and Accrual Methods of Accounting

While the IFRS v. U.S. GAAP rages (or stalls) a far simpler (yet no less important) decision with regard to accounting methods is considered by many small businesses every year.

The cash versus accrual decision is one that all businesses have to make but small businesses have to make and depending on an entrepreneur’s familiarity with the issue, this could be a very simple decision or a “HELP!” moment.

First, a quick refresher:

Cash – You get cash; you record the transaction. You pay cash, you record the transaction. Simple.

Accrual – This is what your copy of Kieso, Weygandt, & Warfield harped on in college. Accounts receivable, accounts payable, deferrals, revenue is recorded when earned; expenses are recorded when incurred, the matching principle, you know the drill.

Before we get to the pros, let’s consider a simple example. If you and some friends want to pool your money together and buy a piece of commercial property, it doesn’t make a lot of sense to go the accrual route. Your tenants pay rent, you record revenue. You pay for supplies to make improvements, you record the expense. In general, don’t make something complicated that is inherently easy.

However, depending on the entity structure of your business, you may be disqualified from using the cash method. Generally, C Corporations, partnership with one C Corp partner, and tax shelters are not allowed to use the cash method. So if any of these apply, hello accrual.

Enough with the elementary crap though, amiright? Thought so. To get some additional insight, we called on a couple of partners who have no problem sharing their opinions: Scott Heintzelman of McKonly & Asbury in Camp Hill, PA and our own Joe Kristan of Roth & Company, P.C. in Des Moines, IA.

Since Scott is effectively the visitors, he’ll get first at bat. He told us that he encourages clients to adopt accrual right away for three reasons:

1) Fewer surprises. I just met with a prospect and the number 1 frustration they had about [their] prior accountant was that CPA encouraged [c]ash but things fell wrong that next year and they got killed with a tax liability.

2) It helps to prevents “games” being played with year end cash receipts and cash disbursements.

3) It helps the company to think like a “grown up” business. Too often a small business thinks and acts small (cash basis is thinking little) when I encourage them to think bigger.

So, according to Scott, if you’re thinking about getting into business you should think BIG, thus, accrual is the way to go.

Is it that simple? Well, maybe but Joe has some other considerations including – what else – taxes, “For tax, cash is normally preferred because of the ability to control taxable income at year-end. Farmers are notorious for stocking up on feed at year-end to manage taxable income, but being able to manage income by paying off A/P at year end is useful for anybody.”

Of course, the more complex your business gets, the cash method is less available:

Where it becomes a disadvantage is in mixed structures or large entities. If you have related entities doing business with one another, accrual is nice because you eliminate a lot of Sec. 267 related party problems. You don’t have to worry about paying a related party for A/P by year-end to get the deduction because they have to accrue the income.

For a simple structure without a lot of related entities, you will want to do your tax returns on a cash basis. As the structure gets more complicated, accrual method becomes more attractive, and likely mandatory under Sec. 448 or in medium to large entities with inventories.

But for anyone that has to produce GAAP financial statements Joe concedes, “I have no idea why anybody would be cash basis. You can’t be GAAP on a cash basis, and lenders don’t like that.”

The lesson? Like everything in this world, it depends. Do you have a complex entity structure with several related parties engaging in business? Accrual might be better. If you want to be the next Google (or even a fraction of Google), then you might as well be on accrual. If your bank requires GAAP financials to get a loan, you’ll be on accrual.

But on the other hand, if you’ve got no use for GAAP and a simple business not looking to get crazy, the cash method may be the way to go. If you’re still nervous about checking one box or the other, don’t worry, nothing is written in stone. Just consult your business or tax advisor and they’ll help you figure this out. Anyone got more advice? Feel free to chime in.