Saving Money on Taxes: Accrual vs. Cash
Feb 02, 2021 by Roger Scherping
Last year I helped a growing client with their first budget. They are in construction, a highly seasonal business, and they were doing their accounting on the cash basis. I helped them understand that the cash basis was not very helpful to them in managing their business. See my blog Cash or Accrual? What’s the Difference?
Very simply, I told them at the time that the cash basis says you recognize a sale when you get paid, but the accrual basis says you recognize the sale when you send an invoice to the customer. I showed them how it made no sense for their books to show that their busiest months were October, November and December (when they got paid), when of course they were busiest in the summer months. We changed them from the cash basis to the accrual basis, and the team feels like their books now accurately reflect their business activity.
Here we are in tax season, and I revisited the cash vs. accrual discussion with them, this time in regards to how they file their taxes. Just as they had a choice – cash vs. accrual – for their books, they have the same choice for their tax return. They were doing their tax return on the cash basis, and I was perfectly fine with that. Most small businesses are.
Why the Cash Basis for Taxes?
Because filing your taxes on the cash basis can reduce your taxes.
Here’s how. Remember that when you use the cash basis, nothing matters until cash is received or spent. On the cash basis we don’t care about when you did the work. It’s only when you get paid that matters. Likewise, it doesn’t matter when your vendor sends you a bill. All that matters is when you pay that bill.
We want our books to accurately reflect the economic activity of our business, so we use the accrual basis for that. But for our tax return we would like to push as much of our profits into the next year as possible because that will allow us to defer the taxes until the next year.
So if we do a job in December but we don’t get paid until January, the tax basis allows us to push that income into the next year. Conversely, paying as many bills as possible on December 31 keeps those expenses into the current year.
Using the cash basis, both of these techniques will reduce your taxable income in the current year. If you file your taxes on the accrual basis, though, neither of these techniques would have any impact on your taxes because when the cash changed hands does not matter on the accrual basis!
So you can see at year end the discretion you have under the cash basis to reduce your taxes. Paying some year end bonuses on December 31 will reduce your taxes. Paying a bunch of vendor invoices before the stroke of midnight will, too. And if you should get a check from a customer but you just don't have time to get it to the bank before they close for New Years, then that will also reduce your taxes because that income will fall into the next year.
The Best of Both Worlds
So that’s why most small businesses use the cash basis for their tax return, even when they use the accrual basis to make sure that their books are as accurate as possible.
Your CPA will help you work through all of this, but hopefully this blog will help you understand why they are having you do things they are.
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Roger