I am Starting Out as an Ad Specialty Distributor. Is It Better to Set Up My Books on a Cash or Accrual Basis for Tax Purposes?
That is a question to be answered by your CPA. As is the case with all tax laws, the answer is not cut and dry, or simple. It is contingent on many factors, such as how your business is structured, the amount of gross annual sales, and whether or not you inventory items.
Allow me to share some basic information so you can better understand the discussion with your accountant.
Cash Basis of Accounting
With cash accounting, you report income when you receive payment from a customer, and record expenses when you pay a supplier or other vendor. Many small businesses use cash accounting. It helps manage your cash flow better. However, the timing of these actual payments made and received for one purchase order can be spread over many months, and thus the actual events of any one month may be deceiving with cash accounting.
Accrual Basis of Accounting
With accrual accounting, you report income when you invoice the customer, and record expenses when they are incurred—even if they have not been paid. The goal is to match income and expenses in your reporting. For this reason, accrual accounting is considered the more accurate reflection of the state of a business because your related payments made and received are always accounted for in the same month. This system allows you to better see your margins. This is the required method for larger, more complex, businesses.
Let's compare how each approach accounts for a sale. This is an extreme one to be sure, but let’s suppose you have invoiced a $100,000 order in December to be paid by the customer the next year. Per the cash basis, you would not report and pay tax on the $100,000 in the current year because you have not received the funds. You would pay tax on this order only after your receive payment from your customer.
Per the accrual basis, you would pay tax on the $100,000 order in the current year. It involves a matter of timing, but you might have difficulties paying tax on $100,000 when you have not received any money from the customer. And, what if the customer is a late pay or worse, a no pay? You are already out those tax dollars. Yes, you would recoup that at a later time if the customer doesn’t pay, but you could have some major cash flow issues by having to pay taxes on an order for which you have not yet been paid.
Make sure to talk to your CPA to understand if you have an option of cash or accrual, and if so, what the pros and cons of each are for your business. It is possible to switch bases, but only with very strict limitations and approval from the IRS, so weigh your options carefully from the beginning.
Please email accounting questions you would like considered for the column to HGatter@AccountingSupportLLC.com with the subject line of "Ask the Accountant."
Harriet Gatter, owner of Accounting Support LLC, was an ad specialty distributor for 23 years and an adjunct professor of accounting at Neumann University. She sold her ad specialty business in 2012, became certified as a QuickBooks ProAdvisor, and now works exclusively with ad specialty distributors nationwide on their QuickBooks, order management and accounting needs.