Cash method accounting is the alternative to accrual accounting. In accrual accounting, everything is recognized as the event happens, regardless of when cash is exchanged. The difference in cash method accounting is that everything is recognized when the cash changes hands. Revenue and earnings on the cash method are recognized as when cash is received rather than when the service is delivered. Costs are recognized when paid for, rather than when used to complete a project.
Who can use cash method accounting?
Most countries require accrual accounting for all businesses, but the United States allows cash method accounting for relatively small privately held service businesses, such as doctors, lawyers, consultants, software developers, real estate companies, training companies, etc. the key issues are: 1) they are not publicly traded companies, 2) they do not have inventory and 3) their revenue is less than $10 million per year.
What is the advantage of cash method accounting?
Cash method accounting helps small companies because it allows them to defer taxes. At the end of a company’s tax year, if a customer owes money, the company can ask that the customer not pay until a few days into the following year. This allows them to defer recognizing that revenue and profit until the next year. On the other hand, if the company owes money to vendors, it pays these bills prior to the year end (often paying final bills December 31).
By accelerating costs from next year to this year and deferring revenue from this year to next year, the company owes less in taxes. Cash method accounting does not mean you get out of paying taxes, just that they are deferred which helps a company’s cash flow.
Since accrual method accounting provides the only accurate picture of your revenue and profitability, it is recommended that even companies who can use cash method accounting should keep the books on the accrual method to see an accurate picture of where they stand. These companies will use the cash method for tax reporting only.