A major topic that businesses have to struggle with upon being formed is the question of whether their accounting will be handled on a Cash-basis or an Accrual-basis. This decision is a fairly major one considering it influences several aspects, including their taxes, and some businesses don't even get a choice on which one they would prefer based on certain factors. It can be a bit confusing, so we here at FRTB LLC will attempt to explain it as simply as possible for those who need to know.
To start with, Cash-basis works on the principle that you only record revenue once you personally receive the cash and record expenses after you spend the cash. Until that money is in or out of your pocket, it goes unrecorded. Small businesses that don't have to worry about inventories or liabilities tend to prefer this model since its easier to work with, and you can't be taxed on money you don't have yet. But it technically goes against Generally Acceptable Accounting Principles (GAAP) that are mandatory for larger businesses to adhere to.
In contrast, Accrual-basis works on the principle that you record revenue and expenses when they are earned, regardless of whether money has been received or paid. That means when you order something, its an expense even if the payment hasn't been taken out, and if you provide a service or sell something, you have to record the revenue even if it hasn't been received from the client. This system has an easier time being used to model future revenue and expenses and falls in line with the guidelines set by the IRS. It is also mandatory for businesses that handle an average of $26 Million in Gross Receipts (revenue from all sources) over the last three years, or are a Tax Shelter, to use this method.
If you're running a small business, using the Cash-basis is often the best solution because you won't have to complicate things. Especially when you are just starting out and can't afford to be taxed on money you haven't received yet. But if you have aspirations to become larger, you'll have to become more comfortable with the Accrual-basis.
When that happens, or if you fail the Gross Receipts Test, you'll need to file a Form 3115 with the IRS to request the change.
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