May 19, 2022

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Ask Doug & Polly: What’s better for your business: cash or accrual accounting system? | Business News

With accrual-based accounting, the company matches revenue and expenses regardless of the timing of cash movement. This creates the need for a series of other balance sheet items to account for the timing differences between revenue or expense recognition and cash movements. Inventory, accounts receivable and accounts payable are examples of such accounts.

Another benefit of cash accounting is that it typically has the effect of deferring some taxes, because it typically recognizes revenue more slowly and expenses more quickly than accrual systems.

For example, a company starts a $25,000 job on Dec. 1 and completes it on Dec. 15. The company pays $15,000 for materials and labor used on the job in December. The customer pays on Jan. 20.

With accrual accounting, December will show a $10,000 profit (because the company will recognize both revenue and expenses when the job is completed). The company will need to pay taxes on the $10,000 in the current year.

With cash accounting, December will show a $15,000 loss (because expenses, which the company paid in December, are recognized). Current year taxes will be reduced due to the $15,000 loss.

However, next year’s taxes will be increased by the $25,000 profit that will occur when revenue is recognized in January. If the company’s marginal tax rate remains unchanged, it will pay the same amount of tax, but the tax will be deferred if cash accounting is used.