Accounting Methods

[mkgrady]

Of the two accounting methods available (Cash Basis and Accrual Basis), how does one decide which is better for a small electrical contracting business?

I'm using the accrual basis (AB) but have been told CB is better for small business because it is simpler. In what way I do not know. Either method seems simple to me but I know little about accounting.

My understanding is that on a CB a company recognizes profits when the money is received from customers and that on an AB profits are recognized when an invoice is sent.

I just don't see the benifit of one method over another. Also if I decided to switch to CB are there some restrictions on doing so?

 

[goldstar]

Accrual basis accounting is for a big company with a board of directors and share holders. They consider accounts receivable liquid assets. You also recognize your expenses when you incur them. The best accounting method for a small company is the cash basis. Under a cash basis you recognize your income when you actually receive payment from your customers and you recognize your expenses when you pay them. Under the accrual method, when your tax year ends you'll have to declare those receivables as income and pay taxes on it even though you haven't received the $$$. Under the cash method you can defer your deposits to the following month so that you don't have to pay taxes on that income until the following year.

Why does that make a difference ? Let's assume that your tax year ends on 12/31 and let's assume that you had a banner year in terms of work and revenue. With the drastic changes in our economy and the possible lack of new work around there's no guarantee that you'll have a banner year next year. Under the accrual basis you'll be declaring income and paying taxes on revenues that you haven't collected. Under the cash basis you'll still have to pay the taxes on the income but you can defer it for another quarter by depositing the income you received in January.

I hope this makes sense.

 

[laketime]

ask your accountant

 

[mkgrady]

Accrual basis accounting is for a big company with a board of directors and share holders. They consider accounts receivable liquid assets. You also recognize your expenses when you incur them. The best accounting method for a small company is the cash basis. Under a cash basis you recognize your income when you actually receive payment from your customers and you recognize your expenses when you pay them. Under the accrual method, when your tax year ends you'll have to declare those receivables as income and pay taxes on it even though you haven't received the $$$. Under the cash method you can defer your deposits to the following month so that you don't have to pay taxes on that income until the following year.

Why does that make a difference ? Let's assume that your tax year ends on 12/31 and let's assume that you had a banner year in terms of work and revenue. With the drastic changes in our economy and the possible lack of new work around there's no guarantee that you'll have a banner year next year. Under the accrual basis you'll be declaring income and paying taxes on revenues that you haven't collected. Under the cash basis you'll still have to pay the taxes on the income but you can defer it for another quarter by depositing the income you received in January.

I hope this makes sense.

Thanks for a well thought out response, Yes it makes sense but it makes me wonder under what circumstances using the cash basis you would not delay depositing checks at the end of the year. For exampls lets say every year you had a gross income of 100K, and at the end of the year you deposit payments of 20K in January that were received in December. Or take an extreme example of not depositing any payments received after September until January 1st. In each case you have reduced your profits for last year, thereby reducing your tax burden. But in both cases you have made your income more for the following year, which increases your tax burden.

I'm thinking your method as explained is only helpful if you have years where you can show a loss and use those loss years to offset profit years. Do I have this right?

 

[mkgrady]

ask your accountant

I plan to do that after learning a few things from people in my shoes. Sometimes your accountant will give you the best answer for your business but they typically will not educate you so that you will understand the answer.

 

[goldstar]

Thanks for a well thought out response, Yes it makes sense but it makes me wonder under what circumstances using the cash basis you would not delay depositing checks at the end of the year. For exampls lets say every year you had a gross income of 100K, and at the end of the year you deposit payments of 20K in January that were received in December. Or take an extreme example of not depositing any payments received after September until January 1st. In each case you have reduced your profits for last year, thereby reducing your tax burden. But in both cases you have made your income more for the following year, which increases your tax burden.

I'm thinking your method as explained is only helpful if you have years where you can show a loss and use those loss years to offset profit years. Do I have this right?

While we all like to be optimistic, I always defer my deposits because you never know whether you'll have a banner year in the upcomming year. Granted, you'll be paying taxes on the $$ you made no matter what but why pay in the year prior and short yourself on ready cash for the new year ? Sorry, I just think of wierd things like that.

 

[mkgrady]

While we all like to be optimistic, I always defer my deposits because you never know whether you'll have a banner year in the upcomming year. Granted, you'll be paying taxes on the $$ you made no matter what but why pay in the year prior and short yourself on ready cash for the new year ? Sorry, I just think of wierd things like that.

That makes sense. I'm on an accrual basis. So if I am having a good year I can delay invoicing customers in December and just do it January 1st to achieve the same result.
Is there any drawback to that?

 

[lightitup]

That makes sense. I'm on an accrual basis. So if I am having a good year I can delay invoicing customers in December and just do it January 1st to achieve the same result.
Is there any drawback to that?

I have found that delayed invoicing, is NEVER a good thing.
It at times might mean you don't get paid. If customer runs short of money - do to cost over runs or just poor planning.

My accountant set me up over 25 years on CB, and I haven't really seen a good reason to change it.

One thing that kind of iritates me - from well meaning people who say when you don't paid on a certain invoice "Well at least you can right it off." On a cash basis,
it doesn't work that way. However it was was never declared as income in the first place. I ussually respond with "How would you like it if you're employer didn't pay you? You now don't need to claim the missing pay as income"

 

[goldstar]

That makes sense. I'm on an accrual basis. So if I am having a good year I can delay invoicing customers in December and just do it January 1st to achieve the same result.
Is there any drawback to that?

The only drawback that I could see is if you haven't been paid from customers who owe you from two or three months back. On an accrual basis you would have to declare that as income even though you haven't received the $$. It's not so bad if it's small money and you have a sizable amount of cash. But, if you're owed 10's of thousands $$ it starts to hurt and make you cash poor. Most smaller contractors are generally undercapitalized or may not have the where-with-all to get additional financing or a line of credit.

As a rule I would never delay invoicing a customer. Many are on a 30-60 day pay cycle (and that's 30-60 days after THEY receive your invoice and not the invoice date). If you delay it a month now you're on a 60-90 day + schedule. That's just bad business practice IMHO.

 

[petersonra]

There are benefits both ways. I don't think it makes any real difference in the long run.

AB accounting helps you to understand the true state of your business. But its not that important to know some of that stuff if you can keep most of it in your head.

Once you get to a certain size it is tough to run on a cash basis and really know where you are at financially.

AR and AP become very important issues then.

It may also make a difference to your bank.

 

[Sparky555]

This is a question for your accountant, but I believe if you decide to change methods you have to explain to the IRS why you are changing methods. I'm a zero in accounting but I believe cash is easier, accrual gives more accurate financial reports.

For a small contracting business you don't have to look much further than your bank balance, accounts receivables and accounts payables to know the condition of the company finances. In my case AR and AP are so close to zero that the bank balance alone tells me where I am.

 

[mkgrady]

There are benefits both ways. I don't think it makes any real difference in the long run.

AB accounting helps you to understand the true state of your business. But its not that important to know some of that stuff if you can keep most of it in your head.

Once you get to a certain size it is tough to run on a cash basis and really know where you are at financially.

AR and AP become very important issues then.

It may also make a difference to your bank.

I started this thread thinking mostly what you have said here. After reading all the responses I feel more confident that in a small contracting business one method is not better than another.

 

[kwired]

One other thing although in the big picture is no different.

If you collect sales tax from your customers with the acrual method that tax is due after you invoice it whether your customer has paid you or not. With the cash method that tax is not due until you get paid.

Writing off not getting paid does not happen with cash method because you never were paid. However your expenses for that customer, if you paid them, are written off because you paid them. Your potential income does not get written off if you never received it.

The opposite is true with accrual method but works out same in long term. You report income when you invoice customer, you report expenses when they are billed to you. If a customer does not pay you you still have reported that income. Some time later when they finally pay you, you do not record any additional income because it was done at invoicing time. If you determine that you will not get paid you can "write it off" to offset your loss but that is actually entered as a separate expense. And if they should happen to pay you after that then it is a new sale transaction.

 

[MarkyMarkNC]

This is a question for your accountant, but I believe if you decide to change methods you have to explain to the IRS why you are changing methods.

I think I recall my accountant telling me the same thing when I set the company up. IIRC, he said they only allow you to change methods once every certain number of years as well.

 

[kwired]

If you change methods you would need to make adjustments when setting up the new method to offset what loss or profit differences there are at time of change.

For example if you have invoiced customers but have not been paid by them yet at the transition time, they are income if switching from cash to accrual, but they are an expense if switching from accrual to cash. The same but in the opposite way applies to any unpaid vendors.

The larger the business with more transactions to examine and process this becomes more complicated.

 

[cadpoint]

Look up the Book "Where Did the Money Go", by Ellen Rohr.

This book and a companion book on business has been mentioned here before. The Sub-Title is: "Easy Accounting Basics for the Business Owner Who Hates Numbers.

I was in that boat, and this book compares the two types of styles that have been talked about above. It presents easy to follow aspects and shows quite a few examples with monetary amounts involves.

Re-reading it again last night, a owner reporting to a book keeper or an accountant is still required to understand the balance sheet and exactly where their numbers are need to be put. IE, Garage in - garage out, can still be possibility.

 

[kwired]

Garage in - garage out, can still be possibility

Must be one big balance sheet