Tax Basis of Accounting – Accrual or Cash

Tax Basis of Accounting

This is the most often asked question by all new businesses.  Should I be on the cash or accrual basis of accounting for tax purposes?  The common layman would always answer ‘CASH BASIS’ for tax purposes.  They say this because they understand that you only pay the tax on the cash that you keep.   But for us tax preparers and authorities on this subject, the answer is ‘IT DEPENDS’.  

There is a difference between the two types of reporting formats.  In general, Generally Accepted Accounting Principles prefers businesses to use the accrual method of accounting for book purposes.  However, the IRS allows you to elect your method, but once elected, you are not allowed to switch without permission from them.  They do not want you to play the ‘tax game’.  For the new business you must choose wisely.  If you choose poorly, there is a high likelihood of paying too much tax too early.   So how do you choose?  Well, the answer is a lot simpler than you may think.  The following sections describe the two choices and it should be obvious to you which way to go.  If you can’t figure it out, send me a note via the comments section below and we’ll communicate via e-mail after that and I’ll help you out. 

                     

          Cash Basis for Tax Purposes – The Most Common Selection

One of the primary requirements for any new business is to retain as much cash as possible early on to use this cash to fund operations and growth.  Any form of income tax payment during the early years of business takes away from capital to continue expansion and fund the growth of the company.  To address this, most businesses select the cash method of accounting for tax purposes.  This is due to the propensity for most new businesses to be in the lending mode.  What this means is that new businesses extend credit to new customers.  

Under the tax code, this extended credit in the form of sales can be deducted from the accrual set of books as an adjustment to reflect the cash basis of accounting.  Thus, the difference is much less profit to pay taxes on April 15th.  Allow me to illustrate: 

Assume that your summation profit and loss statement for the calendar year looks like this: 

Sales                                        $380,000
Cost of Goods Sold                  210,000
Gross Margin                            170,000
Expenses                                     80,000
Net Profit                                  $90,000 

If you are on the accrual basis for tax purposes, then you are obligated to pay income taxes on the full net profit.  If your income tax rate is 20%, then you owe $18,000 in taxes.  But let’s find out what happens if you elect the cash basis of reporting to the IRS and on the last day of the year, the combined total of receivables from your customers is $38,000.  Now what happens?  Answer:  you subtract this receivables balance from the net profit to reflect what you actually received in cash for the calendar year.  The formula is as follows: 

Sales                                           $380,000
Cash Adjustment for A/R             (38,000)
Cash Basis Sales                        $342,000
Cost of Goods Sold                     210,000
Gross Margin                                132,000
Expenses                                         80,000
Net Profit                                      $52,000 

Now the business only pays taxes on $52,000 of income.  At 20% this equals $10,400.  This is a savings of $7,600 over the accrual method for tax reporting.   Notice how the adjustment is made to the Sales section of the profit and loss statement and not to the bottom line.  This is how it is reported to the IRS on the tax return. 

So you can see the advantage of using the cash basis of tax reporting for a new business.  The additional cash of $7,600 will go a long way in funding growth during the next calendar year. 

The business attributes that warrant cash basis of tax reporting include the following:

  • High Growth Rates (exceed 12% per year in overall revenue and gross margins)
  • Extension of Credit to Customers
  • Prepayment of Materials Requirement Before Delivery
  • A Greater Emphasis on Fixed Costs over Variable Costs (Hospitality Industry) 

Examples of businesses that should select the cash basis of tax reporting include: 

  • Professional Service Businesses such as Lawyers, Accountants, Architects,
  • Medical Businesses such as Private Practice, Specialty Groups, Dentists, Pharmacy, etc.
  • Other Licensed Professionals including Mental Health Therapists, Surveyors, Auctioneers
  • Retail that offer Accounts to Customers (Office Supply, Printers, Technology Providers & Tooling)
  • Insurance Brokers
  • Construction Based Contractors (Residential & Light Commercial)
  • Construction Trades (Electricians, Plumbers, Mechanics, Framers, Brick Layers, Flooring, Cabinetry, Painters, Trim, Landscaping, Site Developers & Others)
  • Transportation Based Operations (Trucking, Grocery Vendors, Delivery Companies including Movers)
  • Hospitality Based Operations (Golf Courses, Event Operators, Caterers)
  • Real Estate Agents/Brokers 

The overall conclusion to select cash basis over accrual is that costs of operations and services precede the traditional payment for the services.  In effect, you bill your customers for the services or products provided. 

Accrual Basis for Tax Purposes – The Best Fit for Some Small Businesses 

On the flip side of cash basis reporting for tax purposes is the accrual based.  The most common characteristic of businesses that should choose this form of tax reporting are those operations that get paid immediately for the services they render.  The absolute best example is the traditional restaurant.  I’m not talking about the caterer; I’m referring the sit down family restaurant whereby the family patriarch pays for the food right after dinner is over.  Notice how the business gets the cash right there on the spot.  But, often the restaurant has not paid for the supplies for that dinner served.  Odds are that the meat is on an account with a supplier as are the vegetables.  So here it is critical for the restaurant to match the costs for that meal served against the revenue recorded. 

So let’s illustrate this in a mathematical way.  Suppose this restaurant had the following CASH BASIS of a profit and loss.  That is, we only report the actual cash payments out and the corresponding cash receipts for meals serve for the entire year. 

Cash Sales (All Sales as No Sales are on Account)          $645,000 *Customers pay via cash, debit, or credit cards
Cost of Food and Service (All Food and Drinks)                397,000 *Actual cash payments
Gross Margin                                                                       248,000
Overhead (Rent, Management, Utilities, Insurance, Etc.)   183,000
Profit from Operations                                                         $65,000 

The tax on the $65,000 profit at 25% equals $16,250. 

Now, let’s see what happens if we use the accrual basis and account for all that actual food consumed to serve the meals.  In our case, the restaurant has not paid for the last twelve days of meat, vegetables, and supplies.  This equals $16,500.  Now if we use the accrual basis of tax reporting, what will our profit and loss statement look like for tax purposes? 

Cash Sales (All Sales as No Sales are on Account)                $645,000 *Customers pay via cash, debit, or credit cards
Cost of Food and Service (All Food and Drinks)    397,000                   *Actual cash payments
Additional Accrual Cost of Food                               16,500
A
ccrual Based Cost of Food and Service                                  413,500 
Gross Margin                                                                             231,500
Overhead (Rent, Management, Utilities, Insurance, Etc.)         183,000
Profit from Operations                                                               $48,500 

Under this tax reporting format, we only pay taxes on the $48,500 and at 25% this equals $12,125. 

The difference between the two reporting formats is $4,125.  So you can see the value of the accrual reporting format for tax purposes for those businesses with revenue streams that are mostly cash, debit, credit card based. 

The following are perfect examples of businesses that should elect the accrual form of accounting due to the nature of getting paid immediately upon making the sale or rendering the service: 

  • Restaurants
  • Hair Salons
  • Golf Courses
  • Movie Theaters
  • Recreational Based Businesses
  • Auto Repair Facilities
  • Gas Stations/Convenience Stores
  • Grocery Stores
  • Traditional Retail
  • Clothing/Shoe Stores 

Conclusion 

The key to the tax reporting format is based on the timing of the receipt for products or services.  If compensation is immediate, than the business should elect accrual basis reporting to have the opportunity to include those costs for the products and services that may not get paid until well after the receipt of money.  On the other hand, if your business pays for the materials and supplies up front and sells a product or service and there is a delay in getting receipt of the money, it is generally wiser to elect the cash basis of reporting for tax purposes.  If you are in doubt about your situation, send me a comment below explaining your operation and I’ll send you an e-mail with some guidance in selecting the best method.  Act on Knowledge.

If you have any comments or questions, e-mail me at dave (insert the usual ‘at’ symbol) businessecon.org.  I would love to hear from you.    

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About David J Hoare 427 Articles
I spent 12 Years as a Certified Public Accountant, Over 20 Years of Practice in Accounting and Consulting, Controller in Management of Closely Held Operations, Masters of Science in Accounting, Prepared over 1,000 Business Tax Returns and Hundreds of Individual Returns

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