ACCOUNTING

Cash vs. Accrual Accounting

As if accounting wasn't already complicated enough, did you know there is more than one way to keep track of and report all of your business transactions? That's right, you get to choose between cash basis and accrual accounting. The difference between the two is actually pretty simple: Cash basis taxpayers record transactions when cash changes hands, while accrual taxpayers record transactions when work is performed. While this might seem like a minor difference, it could have a pretty big impact on your financial results.

UBER DRIVER / RIDESHARE

Last year, Andrea became a full time Lyft driver. This year, when she was preparing her first Schedule C she checked the cash basis accounting box on line F. Since Andrea elected to be a cash basis taxpayer, she would record her expenses when she pays for things and her Lyft earnings on what ever day Lyft pays her. Since Andrea's business is pretty straightforward, cash basis accounting should be easy for her to maintain and suit her business needs well.

PROFESSIONAL SERVICES

Emma is a sole practitioner lawyer with over two dozen clients. Typically, Emma bills her clients for services provided upon completion and gives them 30 days to pay. Since Emma usually goes a few weeks before collecting, she would benefit from using the accrual method of accounting, which dictates that she record revenue for her services when she completes her work (invoice date), not 30 days later when she is paid. For example, if she sent an $500 invoice on December 15th, 2017 and collected payment on January 10th, 2018 she would record the $500 as part of gross revenue in December on her 2017 tax return, whereas a cash basis taxpayer would record revenue in January upon receiving payment. Even though she may end up paying a bit more tax in the first year she files, the accrual method provides Emma with a more accurate picture of how well her business did during 2017.

DESIGNER

Miller is a sole proprietor graphic designer who is has been filing as a cash basis taxpayer for the past two years. In 2015, he spent $3,000 on a new computer to use in his business. Even though he is a cash basis taxpayer, since the computer is an asset with a useful life of more than one year, in most cases he would need to depreciate it and deduct the expense over many years the same way an accrual basis taxpayer would.

ENTREPRENEUR

Rale is an entrepreneur who sells a software as a service product to his customers. His software costs $1,200 per year and is billed annually on the day his customers first sign up. If Rale used the cash method of accounting, he would likely find that his gross receipts would vary quite a bit each month. It could be difficult for him to project revenues and make estimated tax payments. Further, he would be recognizing revenue for an entire year before doing anything! Alternatively, if Rale used accrual accounting he would record $100 per month ($1,200 annual subscription / 12 months) over the term of each subscription sold as the revenue is earned. He might even find that this method ends up saving him money during the first year he prepares his Schedule C (i.e. $1,200 subscription sold in December would only have $100 of revenue instead of $1,200).

REAL ESTATE AGENT

Joshi is a real estate agent who is getting ready to prepare the Schedule C for his second year of business operations. Last year when he completed his initial return, he chose to report on a cash basis since he wanted to defer paying taxes on a $23,000 commission he had earned but had not yet received as of year end. This December, he was paid an upfront consulting fee that he did not want to include as part of his gross revenue, so he submitted Form 3115 to request a change in accounting method so he could record the consulting fee as income next year when he earns it, under the accrual method. Unfortunately for Joshi, the IRS will likely deny his request to change accounting methods since what ever basis you choose needs to be applied consistently each year. Note however that under different circumstances / if Joshi had an actual business reason for switching accounting methods, the IRS may allow him to do so.

HOW HURDLR WORKS FOR
RIDESHARE DRIVERS

NOTES ON CASH BASIS VS ACCRUAL ACCOUNTING

If you use cash basis accounting you generally will recognize revenues and expenses when cash is received from customers or paid to vendors.
If you use accrual basis accounting you generally will recognize revenues when you provide your customers products or services, and record expenses when vendors provide you products or services. Keep in mind that if you use the accrual method, revenues and expenses are typically recorded when there is economic performance, no regard is given to when cash collections and payments are actually made.
The cash and accrual methods are topics found in financial accounting as well as tax accounting. Typically, accrual accounting will give you a better indication of the financial health of your business and it is considered to be more accurate, however, it does involve a bit more work. Note that in financial accounting, the Generally Accepted Accounting Principles (GAAP) only permit use of the accrual method.
The IRS has a some exceptions for both cash and accrual accounting. For example, if you are a cash basis taxpayer and you purchase an asset with a useful life of more than one year, the full cost of the asset generally may not be deductible in the current year. if you are an accrual basis taxpayer you cannot deduct expenses owed to a cash basis taxpayer who is a related party until the expenses have actually been paid. Refer to the IRS Publication 538, Accounting Periods and Methods, for additional information surrounding exceptions.
You can choose the cash method, accrual method, or any other IRS approved method of accounting the first year you file your Schedule C, however, the method you choose needs to be applied consistently each year. If you want to change your accounting method after you file your initial return, you need to submit Form 3115 and obtain IRS approval. Note that changing accounting methods can be a challenging process; if possible you should try to avoid doing so.

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