ACCOUNTING TIPS & NEWS
Should I Choose Cash or Accrual Basis Accounting for my Business?
By Anna Kovchina, CMA & Founder of AKcounting, LLC – ak-counting.com
Businesses must choose between cash basis and accrual basis accounting methods. Cash basis accounting is straightforward, tracking revenues when cash is received and expenses when cash is paid. In contrast, accrual basis accounting offers a more precise representation of a company’s financial status by recording revenues when they are earned and expenses when they are incurred, regardless of actual cash transactions. Generally, you can choose any permitted accounting method when filing your first tax return. However, you must use the method consistently year to year, and it must clearly reflect your income. Many new small businesses initially choose the cash basis as it is easier and quicker, but as companies grow, they may need to convert to the accrual basis.
2 Common Reasons to convert Cash to Accrual
Business owners need to weigh the pros and cons of cash versus accrual accounting methods from the beginning. Companies with inventory, organizations collecting advance payments, start-ups anticipating rapid growth or seeking investors should estimate if using accrual method is required or beneficial for them from the start. Most of the growing companies should weigh the pros and cons of conversion at some point of their development.
Common reasons for changing accounting methods include:
1. LEGAL REASONS
- The company grows large enough that the IRS no longer permits the use of the cash method.
- The company starts holding inventory or its role in the business grows.
- Changes in legislation.
2. Benefits Reasons:
- Tax benefits, especially for companies receiving advanced payments from clients.
- Seeking investors or loans when accrual-based financial statements are required.
- Obtaining better financial insights with the accrual method, enabling better decision-making.
Some companies decide to continue using the cash method for tax purposes and the accrual method for analysis reason or attracting investors.
TIP: Evaluate the pros and cons of accounting methods at the end of the tax year to implement changes for the next year if necessary. Don’t forget to file Form 3115 if changing the accounting method for tax purposes
HOW to Convert Books from Cash to Accrual
1. Set Up Missing Accounts in the Chart of Accounts:
2. Evaluate Operations for Differences in Recording:
Identify which transactions are recorded differently under cash and accrual methods. Bills incurred but not paid and revenue earned but not received are obvious examples. Less obvious situations include advance payments from customers recorded as deferred revenue and subscriptions billed yearly recorded as prepaid expenses. For a SaaS company, customers invoiced yearly have revenue recognized monthly until the software agreement ends. Accrue for vacation time if a vacation policy exists.
TIP: Use recurring transactions to set up monthly expense recognition. QuickBooks Online Advanced has a new revenue recognition feature.
3. Determine the Date and Make Adjustments:
Ensure correct opening balances for all accounts on the date of adopting the new accounting method and understand the effect of these changes on the income statement. Record open bills and invoices, set up recurring transactions, and adjust account balances with journal entries where necessary.
4. Ensure Team Compliance with New Procedures:
Ensure all team members follow the new accounting procedures, including recording bills and invoices, distinguishing yearly and monthly subscriptions, following revenue recognition procedures, and making accruals for earned time off.
5. Perform Timely Reconciliations:
ABOUT ANNA KOVCHINA, CMA
Anna Kovchina, CMA is the Founder of AKcounting, LLC. Anna Kovchina has extensive experience in financial accounting from multinational corporations – including Hyundai – to emerging startups.
“I believe clear communication is the most important aspect of my role. Clients know they can expect professional, dependable support and and that I will get to know their businesses to provide the best guidance and advice possible.”
Get more helpful tips and information about Anna’s Bookkeeping and Accounting for small and growing businesses at AK-Counting.com
