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Choosing a Method of Accounting
by Peter Soh, CPA
You are a bold and bright entrepreneur but have no clue about accounting.
You want to minimize taxes but want to show a fabulous financial picture
for your investors. What do you do?
The two principal methods of accounting are the cash and accrual
methods of accounting. You can also have two sets of books: one for
tax and one for financial accounting. Under the tax regime, you must
follow IRS or state tax authoritative guidelines. Under financial accounting,
you may follow GAAP( Generally Accounting Accepted Principles).
Checkbook Accounting
The cash method of accounting allows your business to recognize income when
received and incur expenses when paid. Basically, think of your checkbook.
The cash method is advantageous for tax purposes because income can be deferred
to the next year by either delaying invoices or asking customers to pay after
year-end. Expenses can also be accelerated into the current year by simply
prepaying some future expense items like rent or insurance. Credit card bills
are considered cash when you incur the charge. Also, if you receive a check
and fail to cash it, the receipt of the check is considered income on the
date of receipt not when you actually put it in the bank. Under tax law,
your company may use the cash method of accounting if gross receipts are
less than $5,000,000 for the past 3 years, does not carry any inventory,
and is not a C corporation.
Accrual Method of Accounting
In regards to the accrual method, revenue is recognized when earned and expenses
are booked when incurred. To put this sentence in common English terms, revenue
is recognized when invoiced to the customer and expenses are booked when
you are billed. For example, your company invoices customer X for $500 on
12/31/99. It must recognize revenue of $500 on 12/31/99. If the company receives
a bill from vendor Y of $200 on 12/31/99, it must book the expense on that
date. The accrual method is acceptable under tax and GAAP provisions.
Two different sets of Books
A company may use the cash basis for tax accounting, and the accrual basis
for financial reporting. It can have the best of both worlds. Review this
example!!
On 12/31/99, Company A has $8,000 of accounts receivable - outstanding
invoices and $500 of accounts payable - outstanding bills. It has collected
$5,000 of cash for the year and paid $2,500 of expenses with a balance
of $2,500 on its checkbook. The company is a S corporation, has no
inventory, and has gross receipts of less than $5,000,000 in the last
3 years.
For financial statement reporting purposes, Company A will report
revenues of $13,000 (Cash + A/R) and expenses of$3,000 (Cash + A/P)
for a net profit of $10,000 on the accrual basis. For tax purposes,
Company A will report revenues of $5,000 and expenses of $2,500 for
a net profit of $2,500. We have accomplished our goal of maximizing
profits for financial reporting and minimizing profits for tax reporting.
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