Cash versus Accrual Basis for Tax Reporting

Jul 27, 2015

Small businesses (defined as businesses with annual gross receipts between $1 million and $10 million, according to the IRS) can opt to report their taxes using either the cash or accrual basis of accounting for their first tax return.  Most small business owners, if given the option, will choose to report using the cash basis as it is easier for many businesses to keep track of.

In order to elect to report using the cash basis, businesses must have annual gross receipts of less than $5 million and cannot carry an inventory.  Under cash reporting, income does not need to be recorded until payment has been received.  Expenses are not recorded until the money leaves the account.  However, if a business has first year sales of over $5 million a year or if a business carries an inventory of items that are sold to the public, it must use the accrual basis for filing its tax return.

Under the accrual method, revenues are reported at the time the service or product has been delivered and billed to the customer.  Expenses are recorded when incurred or invoiced although the actual payment may not have been made.  One of the reasons that a business owner might prefer the cash basis for tax reporting is that under the accrual method, a business owner could wind up with a large tax bill without, in the case of a late paying customer, necessarily having received the cash to pay it.

Whichever method is chosen, once the initial tax return has been filed, a business must continue to use the same method in future years unless a change in reporting method is applied for with the IRS.  The more common situation is to convert from cash to accrual basis of reporting.  This may be due to a need to convert to GAAP (Generally Accepted Accounting Principles) reporting as a result of a refinancing or change in lender requirements.   GAAP approves the accrual, not the cash basis, method of accounting

Another reason that a company that had chosen the cash method would need to convert to the accrual basis is if that company’s average gross receipts for the most recent tax year added to the two prior years (last three years divided by three) exceeds $5 million (as of 2012).  This would mandate a change to the accrual basis of tax reporting.    

As stated earlier, in order to change tax reporting methods, an application to the IRS is required to be filed using Form 3115, Application for Change in Accounting Method. http://www.irs.gov/uac/Form-3115,-Application-for-Change-in-Accounting-Method.  A tax filer can obtain “automatic consent” by attaching it to a timely filed return.  

This is one area in which a B2B CFO® partner can be of assistance in helping determine which method a small business owner should be using for reporting purposes.  He or she can also assist in converting from either method to the other.

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