The end of the year is coming up and my wife has a big accounting decision to make. This year, my wife started a music studio. Since it’s her first year of operation, she has to pick an accounting method to properly report the taxes owed from the business.
Perhaps you’ve never given your choices much thought. Maybe you were not aware that there are different methods of accounting, but the choices available can greatly change your tax liability.
If you are a giant corporation, there are no options for you. You must use accrual based accounting. It’s not the same for small businesses like my wife’s studio. She is allowed to use either cash or accrual accounting.
Cash accounting is most popular, because most small business owners are everyday people. The method works a lot like keeping a check register. Every time someone hands you cash, you recognize that you’ve made a sale and every time you pay a bill, you recognize that an expense has been incurred. That’s why it’s called cash accounting. The mere movement of cash triggers your accounting to recognize profit and loss.
Accrual accounting is completely different. Recognizing a sale or an expense has nothing to do with paying out or receiving cash. Instead, it is based on the nature and timing of the business transaction. Sales are recognized when earned and costs are expensed when they are incurred. It’s not enough to collect money from a customer, if you haven’t fully delivered the product or performed the service; then you haven’t really made a sale yet.
My wife bills her lessons quarterly. Since her business is based on appointments, this keeps her income steady and helps prevent people from missing appointments. However, it does create a big difference for her taxes this year.
Soon she’ll be collecting money for the next 12 weeks from 4 of her students. Based on the cash accounting method, all of the money she receives is taxable this year. It doesn’t matter, that only one of the 12 lessons being paid will be in December.
The accrual based method treats the situation very differently. Even though my wife is collecting a large check, the accrual method allows her to only recognize the sale of the one lesson she’ll perform before the month’s end. The revenue from the rest of the 11 lessons won’t be recognized and taxed until next year.
It’s hard to say which method is the best for my wife. Since my wife started her business in September, She has the option of accelerating or deferring a large portion of her tax liability. Most tax professionals advocate that the default position should be to defer your taxes. However, my wife hasn’t earned a full year of taxes this year. It might make sense to keep next year’s tax liability smaller by selecting the cash based method.
Whatever she chooses, she’s going to have to live with her decision. You aren’t allowed to change accounting methods every year. Once she’s picked a method, she’ll need to stick to it going forward. However, the choice can have significant consequences on this year’s tax bill.