Q: If an accountant’s wife can’t get to sleep, what does she say?
A: “Tell me about work today, dear.”
Welcome to Round 2 of Accounting 101. In another article, I talked about inventory timing and the effect that can have on your tax bill each year. (Absolutely fascinating stuff, I know.) A similar phenomenon can occur based on whether a business uses “cash basis accounting” or “accrual basis accounting”. As with inventory accounting, theoretically and over time these differences even out, but timing differences can cause unexpected issues.
Here are the differences between “cash basis accounting” and “accrual basis accounting”
Cash Basis Accounting
First, what is cash basis accounting, and what is accrual basis accounting? What’s the difference between the two? Cash basis accounting is simple: when you receive money, you recognize it as revenue and when you spend it you recognize it as an expense. Money in equals sales. Money out equals an expenditure (assuming it actually was a business expense, of course).
Accrual Basis Accounting
Accrual basis accounting is a little different. Under accrual accounting, income is recognized when it is earned and expenses are recognized when they are incurred. The actual date of the receipt or disbursement of cash is not taken into consideration.
Throughout the year this doesn’t make a ton of difference. You receive a bill in January and pay it in February or a customer pays you in April for an invoice you sent out in March. Who cares? But variances towards the beginning or the end of the year can affect your tax return.
For instance, let’s say you are an accrual basis company and send out a number of invoices totaling $20,000 on December 31. There is no chance that you will receive that money before the year is done, but by virtue of invoicing (and thus demonstrating that you have earned the income), the entirety of that $20,000 is taxable in the current year. If you were having a bad income year to begin with, you probably don’t mind. But if you were already having a bumper year then the last thing you want is more income! It means the tax is due today vs. a year from now and you’re quite possibly paying it at a higher rate. More tax and sooner. Not good.
Cash basis is a little more straightforward but it can trip you up as well. If a business were a cash basis company and invoiced out late in 2014, all of the income is taxable when received in 2015. You might predict this for a December 31 invoice, but what about an invoice from September that a customer doesn’t get around to paying you until February? Since the payment was so late, you might have forgotten it was income for the current year.
None of this is overly difficult to cope with, but it does take appropriate planning. If you just use your bank balance as a barometer for your taxes, you could be in for a world of hurt come April 15th. That’s where proper planning (and sometimes expert advice) come into the picture. Without it, you could very well be paying costly and unnecessary taxes.
Any accounting, business, or tax advice contained in this communication, including attachments and enclosures, is not intended as a thorough, in-depth analysis of specific issues, nor a substitute for a formal opinion, nor is it sufficient to avoid tax-related penalties.