Can you use the cash method for taxes and the accrual method for financial reporting?
Using the accrual method for internal financial reporting can be a good idea for two reasons:
- It produces a more accurate presentation of your business's financial results, which is a prerequisite for effective financial management, and
- It complies with Generally Accepted Accounting Principles (GAAP), which financial institutions prefer when evaluating the financial position of a business seeking financing.
However, from a tax standpoint, the accrual method can negatively affect cash flow.
The cash method of accounting, on the other hand, does the opposite of the accrual method. The cash method does not provide accurate financial information and does not comply with GAAP. But it does provide a tax advantage.
Here's the scoop on both methods of accounting:
Under the accrual method income is reported when it is earned regardless of when payment is actually received and expenses are reported when they are incurred regardless of when they are actually paid.
Under the cash method, income is reported when it is actually (or constructively) received and expenses are reported when actually paid.
A simple example will demonstrate the effect of each method on both financial reporting and taxes.
You perform a service for $5,000 during December 2014 and get paid January 2015. The cost of producing the service is $1,500, which you pay in December 2014. You had no other transactions in December or January.
From a financial reporting standpoint, under the accrual method your income statement would show a net profit of $3,500 for December 2014 ($5,000 minus $3,500). This would be accurate since the $5,000 in income and the $1,500 expense that generated the income were both reported in the same tax year. In other words, income and expenses were properly matched.
Under the cash method, the income statement would show a net loss of $1,500 for December 2014 because no revenue was reported at that time. In addition, under the cash method, the January 2015 income statement would show a net profit of $5,000 because payment was actually received.
As you can seen, the cash method produced a distortion of the financial results for December and January because the income in December and the expenses that generated such income were not properly matched in the correct accounting period.
From a tax standpoint, under the accrual method the $3,500 in net profit would be subject to income taxes in tax year 2014. But under the cash method you would have no tax liability in 2014 since the $5,000 in income earned in December was not reported at that time. Only the $1,500 expense was reported creating a $1,500 loss for December 2014.
Under the cash method, the $5,000 earned in December 2014 would not be subject to income taxes until 2015 when payment was actually received. Since the 2015 income tax return is due April 2016, taxes on the $5,000 earned in December 2014 have been deferred one year past the April 2015 filing deadline. That's cash in your pocket for an extra year.