Accrual Basis Books, Cash Basis Tax Return
Are you a business owner trying to understand why your financial statements show a net loss but your tax return shows net income (or vice versa)? Chances are, the difference is due to using one accounting method for your books and another for tax.
When your tax preparer makes an accrual to cash adjustment, your bottom line can change dramatically. So let's review how a cash-basis tax return can work hand in hand with accrual-basis bookkeeping.
Cash basis accounting vs. accrual basis accounting
First, let's clarify the differences between cash and accrual accounting.
Cash basis accounting
Cash basis accounting is the more simplified form of accounting. You record income when you receive money and expenses when you pay them.
For example, say you own a lawn maintenance company and invoice your client for weekly mowing at the end of the month. On June 30, you send your customer an invoice for $200, and they pay you on July 15. You would record the $200 of income on July 15 when you collected the cash—not in June when you performed the service.
Accrual basis accounting
Accrual basis accounting is a more complex form of accounting. You record income when you earn it and expenses when you incur them, regardless of when cash changes hands. When you use the accrual accounting method, you have accounts receivable, accounts payable, and accrued and prepaid expenses.
Returning to the lawn care example above, using the accrual basis accounting, you would record income each week when you mowed the lawns in June because that's when you earned it by performing the service, even though you didn't collect your payment until July.
Why keep books on an accrual basis?
The accrual basis of accounting is far more advantageous for financial reporting than the cash basis because it provides a much more accurate view of your results of operations.
To illustrate, let's say a customer hires you to perform a big landscaping job. In May, you buy $20,000 of supplies to complete the job. You start the project in early June, complete it by the end of the month, and send your customer an invoice for $50,000 on June 30. In July, your client pays the invoice, sending you $50,000.
Under the cash method, you would have $20,000 of expenses in May and $50,000 of income in July. That's when cash went out and money came in. A casual reader of your financial statements might think you had an awful May and a July.
Under the accrual method, you would recognize $30,000 of gross profit in June because that's when you earned the revenue and used the supplies. This gives you a clearer picture of your financial results because it matches revenue to expenses.
Why pay taxes on the cash basis?
Using the cash basis accounting method for tax purposes can be beneficial in certain situations.
The main advantages of using the cash basis are that it creates a simpler and more straightforward way of calculating your tax liability, and you don't have to pay taxes on income you haven't yet received.
For example, say you provide services in December and send your customer an invoice for $10,000 on December 31, and the customer pays in January. Under the accrual method of accounting, you would include that $10,000 in your taxable income in the previous year because that's when you performed the service. Under the cash method, you won't owe taxes for that job until you have the cash.
The cash basis method also allows you to take advantage of some tax planning to shift income and expenses. For example, you might delay sending invoices to move prior period sales into the next tax year. You can also prepay expenses or purchase supplies in the current period. Making those cash payments now allows you to reduce your taxable income in the current accounting period.
How to convert accrual books to the cash basis for taxes
The good news is you don't have to maintain two sets of books to convert your accrual basis financial statements into a cash basis for tax filing. Instead, you (or your accountant) can make accrual to cash conversion journal entries to get your books on the correct basis for tax reporting.
This accrual to cash conversion can be broken down into a few steps:
Remove accrued expenses and accounts payable
Accrued expenses are those you've incurred but not yet paid for. For example, when you use utilities in December but don't receive an invoice from the utility company until January of the following year, you should record an accrual for that utility expense in the year you used them.
Accounts payable represents money you owe vendors or suppliers for goods and services you received on credit. For example, if you order office supplies with Net 30 terms, the supplier's invoice is an account payable.
To switch from accrual to cash basis, you need to remove any accrued expenses and accounts payable from your expenses.
Add prepaid expenses
Prepaid expenses relate to assets or services you haven't used yet. For example, you might prepay for an entire year of insurance coverage or several months of rent. If you've prepaid any expenses, you need to add those to your expenses.
Subtract accounts receivable
Accounts receivable (AR) is money owed to your business for goods or services you've already provided.
To switch from accrual to cash basis, subtract any unpaid accounts receivable from your revenue.
Add unearned revenue
Unearned revenue includes prepayments from customers before you deliver the product or service.
To convert your accrual books to the cash basis, you need to add any unearned revenue to your net income.
Accrual basis books and cash basis tax reporting can seem like complicated concepts, but it all starts with accurate financial statements. If you need help selecting an accounting method, getting your books in order, or identifying strategies for timing your accounts receivable and payments in the most tax-advantaged way, schedule a call with Slate.