Accounting and tax reporting are interrelated small business functions.
Inaccurate accounting can cripple a firm's income tax reporting ability and lead to an overpayment of taxes. On the other hand, poor accounting can also result trigger an audit and penalties for underpayment of taxes. In either case, accounting systems that are incapable of providing an accurate reflection of income and expenses create a financial risk for the company.
The IRS recognizes the challenges associated with accurate financial reporting. They also recognize that businesses have different approaches and accounting philosophies. So to accommodate businesses, the IRS allows for two form of accounting: (1) cash and (2) accrual.
In the cash accounting method, income is recorded when a check (or cash) is received and expenses are reported when they are paid. Many people consider the cash model to be the simplest accounting method because it is relatively easy to track and record. In the accrual method, income is recorded at the time of sale and expenses are recorded as they are incurred. Although the accrual method is slightly more complex, it paints a more accurate picture of the company's financial position.
IRS Rules: Cash vs. Accrual
All businesses are required to select an accounting method for IRS purposes. Although the IRS doesn't communicate a preference about which accounting method you choose, they are very interested in maintaining consistency throughout your company's taxable lifetime. So once you select an accounting method, you will be required to maintain that accounting method in subsequent tax years. The only way to change accounting methods is to obtain permission to do so from the IRS before you make the transition from a cash to accrual method (or vice versa).
Tips for Business Owners
- New business owners should discuss accounting methods with their accountants well in advance of their filing deadline for their first business return. Since it can be difficult to change accounting methods midstream, you need to be comfortable with the benefits and drawbacks of your choice.
- For the sake of simplicity, most business owners elect to maintain a cash accounting method. Cash accounting can be easily managed by limited, in-house resources and offers flexibility for year-end tax planning.
- Accountants and businesses that have non-regular income streams tend to prefer accrual accounting. Retail operations can also benefit from accrual accounting because it ties inventory purchases to sales, and provides a more accurate picture of the company's position in financial reports.