Choosing an accounting method for your business may seem like an easy task but selecting the right accounting method can make an enormous difference for bank and bonding purposes. An accounting method is a set of rules used to determine how income and expenses are reported on your company’s tax return.

Two of the most common options are the cash and accrual methods of accounting. There are pros and cons for both methods, and one may be a better fit for your business than the other.

Cash Method

The cash method of accounting is the most common for small businesses, oftentimes the most tax efficient, and allows a business to have some flexibility. When using the cash method, a company reports income in the tax year the cash is received and deducts expenses in the tax year paid. Receipt of payment for a job, whether it is in the form of a check, cash, or credit to your account, is reported as income. The taxes due match the cash inflow and outflow of the business. Contractors generally have costs upfront before payment is rendered, making the cash method the most effective tax treatment for their business.

For example, your company is having a great 2022. Instead of paying bills the first week of 2023, have your accountant make a special check run the last day of the year. This will shift your tax deduction from 2023 to 2022.

However, not all businesses are eligible to apply the cash method of accounting. Any corporation or partnership, other than a tax shelter, that meets the gross receipts test, and a qualified personal service corporation can use the cash method. To meet the gross receipts test and be able to use the cash method of accounting in 2022, a corporation or a partnership must have average annual gross receipts of $27 million or less (indexed for inflation) for the prior three tax years.

Accrual Method

The accrual method of accounting is also common and oftentimes provides a more accurate picture of the business’s current position. The accrual method of accounting recognizes income and expenses as they are earned or incurred. For example, if a company buys materials and receives an invoice in 2022 but does not pay until 2023, the expense is deductible on the accrual method in 2022 because the company received the materials, and therefore, constructively incurred the expense.

Businesses change methods of accounting for multiple reasons. One of the most common reasons is they fail to meet the gross receipts test, as defined above. If a corporation or a partnership fails to meet the gross receipts test, then it may need to change its accounting method from cash to accrual in the year it failed the test. The entity must file Form 3115 to request the change. Businesses that prepare generally accepted accounting principle financial statements for their bank or bonding can still use the cash method for tax purposes if they meet the guidelines above.

Please contact your Ketel Thorstenson tax advisor for more information on which accounting method is the best choice for your business.