The accrual method of accounting is the method by which revenues are recorded when earned, and expenses are recorded when they are incurred. A cash-basis method of accounting measures revenue when cash is received and expenses when they are paid. The accrual method must be used for financial statements to be considered prepared according to Generally Accepted Accounting Principles (GAAP). See my blog article Accrual vs. Cash for a detail explanation with sample journal entries.
Full accrual accounting can be tedious and time consuming so many people use a hybrid system. This means using a combination of accrual and cash basis methods when preparing financial statements. Most often, a business will record only Accounts Receivable and Accounts Payable accrual items. In addition, the only Accounts Payable items recorded will be Inventory purchases, since most of the other expenses of the business are paid within 30 days. The value of using the hybrid system is that your financial statements reflect all Revenue and all Inventory purchases. Plus, it is fairly straightforward when adjusting for a cash basis tax return at the end of the year.
Yes, it is possible to have it both ways, i.e., using accrual for your books and cash for your taxes? However, you must remember to adjust your accruals to cash at the end of the year. If you are using a full accrual system, then it may not be practical to have to change over everything from accrual to cash. If you are using a hybrid system (explained above) then all you have to do is adjust your Accounts Receivable and Accounts Payable balances at the end of the year.
For example, let’s say you generated $75,000 in Revenue during the previous year and your Accounts Receivable balance was $25,000 on December 31 of that year. The logical conclusion is that you had $50,000 in cash receipts that are reportable on your tax return. ($75,000 less $25,000 not yet collected)
In the current year you had $100,000 in Revenue but your Accounts Receivable balance was only $10,000. In this case, your reportable cash receipts would be $115,000. Why? Twenty-five thousand in cash was received in the current year but was generated in the prior year (last year’s A/R) and $90,000 ($100,000 less $10,000 not yet collected) was received in the current year and generated in the current year.
| Cash received from the prior year | $ 25,000 |
| New Sales Revenue current year | 100,000 |
| 125,000 | |
| Less: Current year’s Accounts Receivable | -10,000 |
| Total Cash received current year | $115,000 |
When adjusting Accounts Payable for a cash basis tax return, you have a choice. You can remove all the expense items that relate to Accounts Payable such as:
| DESCRIPTION | DEBIT | CREDIT |
|---|---|---|
| Accounts Payable | 5,000.00 | |
| Cost of Goods Sold | 1,500.00 | |
| Telephone | 50.00 | |
| Accounting | 100.00 | |
| Utilities | 200.00 | |
| Advertising | 1,500.00 | |
| Outside Services | 1,000.00 | |
| Repairs & Maintenance | 650.00 | |
| To adjust Accounts Payable items for Cash Basis Tax Return. |
Or, you can do this by setting up a special account:
| DESCRIPTION | DEBIT | CREDIT |
|---|---|---|
| Accounts Payable | 5,000.00 | |
| Accounts Payable Adjust | 5,000.00 | |
| To adjust Accounts Payable items for Cash Basis Tax Return. |
Either way, the point is that you can do it and there may be good reason to do so. You may have high receivables and low payables. This means you could be in for a double-whammy. You will have to report high income and low deductions. This means your taxes will be higher while not having received the cash to pay those taxes. Keep in mind though that you can’t switch back and forth each year from accrual to cash. Once you select the method of accounting for your tax return, you have to stick with it. Otherwise, you will have to have permission from the IRS and a very good reason for requesting a change in accounting method.
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