What is Accrual? What Designers Need to Know
What is accrual accounting vs. cash accounting? If you have been in business for more than a year, you have probably heard these terms before but do not fully grasp what they mean or why they are important. Let’s start by setting your mind at ease and letting you know that you are not alone. Approximately 70% of small business owners do not fully comprehend the difference. However, the designers that understand the difference between cash vs. accrual usually have an advantage in being successful and implementing this knowledge into their firm’s growth strategy.
What’s the difference?
There are only two methods of reporting accounting when it comes to recognizing revenues and expenses, which include cash accounting and accrual accounting. The most basic difference between the two is the time which a business reports income earned and expenses incurred.
Cash vs. Accrual Accounting
Cash accounting by definition is a method of practice in which income is recognized when money is actually received, and expenses recognized when money is actually paid out. This is different than accrual accounting where revenues and expenses are recorded when they are incurred, regardless of when cash is exchanged.
Why it’s important to know the difference…
The reason it is important for designers to fully comprehend the difference between cash and accrual accounting is because most small to mid-level firms file income taxes on the cash basis but it is likely their accounting system reports most accurately on the accrual basis. Another reason designers should understand the difference between the methods is because although a company may file income taxes on the cash basis, the company’s sales tax is most likely required to be filed on the accrual basis. In order to not underpay on income taxes, or overpay on sales tax, a designer would need to understand these two concepts and implement operating procedures. Having a true comprehension of cash vs. accrual accounting will help a design firm more accurately manage cash flow, budget business operations, potentially save money during tax time and operate a better set of overall procedures.
Understanding how design software reports on accrual
Designer software usually reports better on the accrual basis because it provides a clearer picture of the businesses income and expenses matched in the correct year. For example, a designer received a client payment into their bank account on December 20th for an invoice that was previously sent to a client. However, the designer is not ordering anything for that client until after Jan 1st of the following year. On the cash basis, if we were to simply report money received as income, it would overstate net income for the current year and understate offsetting liabilities. On the accrual basis of accounting the designer can record their liabilities as expenses for items that need to be purchased by creating “bills” and in turn only recognizing the actual profit for the client payment and not the income for the full amount paid before related costs. In this example, the accrual net income would be less than cash basis and thus reduce income tax liability for the year.
IRS Requirements for Accrual vs. Cash Tax Filing
Most small to mid-size firms report on the cash basis unless they are above $5million in gross revenues. If a firm or individual brings in more than $5million in sales per year they should be filing taxes on the accrual. If a firm’s gross sales are less than $5million in a year that firm will most likely file income taxes on the cash basis. If you are a small to mid-level designer or firm, you will want to have a practice that allows your books to have very close numbers on the cash and accrual. Large variance in the numbers could indicate a problem in the accounting workflow.
Written by Marissa McKinney, Logistis
Logistis is a cloud-based accounting firm specializing in interior design. Logistis helps carry designers through the entire accounting process, from start to finish. They can set up the financial portion of your office, integrate your systems, run your payroll, prepare your taxes and offer assistance with financial planning along the way.
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