While tax planning has many advantages, there are also some disadvantages as well as limitations to consider. As with anything, there are always two sides to every story. Here are some potential drawbacks and limitations of using accrual basis accounting for tax purposes.
Ease of use
1. It’s more complex. The accrual basis is more complicated than the cash basis and requires more knowledge to correctly implement. This complexity can lead to errors being made, which can in turn lead to costly penalties from the IRS. Also, because the accrual basis relies on estimates, there is always the potential for those estimates to be off, which can again lead to problems come tax time.
2. It’s less intuitive. The accrual basis can be more difficult to understand and follow than the cash basis. This lack of intuition can make it harder to spot errors, as well as make it more difficult to explain your taxes to others (such as your accountant).
3. It can delay the recognition of income. Because the accrual basis allows you to defer recognition of income until it is earned, this can create a situation where you end up owing taxes on income that you haven’t even received yet. This can obviously create cash flow issues and cause problems come tax time. As an example, let’s say you sell a product on credit and don’t receive payment until 60 days later. Under the accrual basis, you would have to pay taxes on the income from that sale even though you haven’t received the money yet.
4. It can accelerate the recognition of expenses. The flip side of the previous point is that the accrual basis can also accelerate the recognition of expenses. This means you may have to pay taxes on expenses that you haven’t actually incurred yet. Again, this can cause cash flow issues and make it difficult to budget for your taxes.
5. It requires good record-keeping. In order to properly use the accrual basis for tax purposes, you need to have good records. This means tracking all income and expenses very carefully and making sure everything is recorded correctly. This can be a lot of work, especially for businesses with a lot of transactions. If you are struggling with keeping good records, seek out the help of a professional.
While there are some potential drawbacks to using the accrual basis for tax purposes, there are also many advantages. When used correctly, the accrual basis can provide a more accurate picture of your business’s financial health and can save you money come tax time. As with anything, it’s important to weigh the pros and cons before making a decision. Talk to your accountant or tax advisor to see if the accrual basis is right for you.
Situation based difficulties
6. It may not be favorable for businesses with few receivables and large current liabilities. While the accrual basis may yield favorable tax results for businesses with large receivables and few current liabilities, the reverse is true for businesses with few receivables and large current liabilities. In this case, it may be better to use the cash basis for tax purposes.
7. It can be difficult to change from a cash basis. If you’ve been using the cash basis for tax purposes and decide you want to switch to the accrual basis, it can be difficult to make the change. This is because you will need to go back and track all of your income and expenses for the previous year (or years) in order to correctly file your taxes. This can obviously be a lot of work, so it’s important to weigh the pros and cons before making a decision. Talk to your accountant or tax advisor to see if switching to the accrual basis is right for you.
What about the advantages of cash-based accounting you ask? In short;
1. It is easier to understand and follow. The cash basis is much simpler than the accrual basis and is therefore easier to understand and follow. This can make it easier to spot errors, as well as make it easier to explain your taxes to others (such as your accountant).
2. It provides a more accurate picture of your business’s cash flow. Because the cash basis only recognizes income and expenses when money actually changes hands, it provides a more accurate picture of your business’s actual cash flow. This can be helpful in spotting trends and making decisions about how to allocate resources.
3. It may be favorable for businesses with large receivables and few current liabilities. Because the cash basis only recognizes income when it is actually received, it can be favorable for businesses with large receivables and few current liabilities. This is because you can defer recognition of income until it is actually received, which can lower your taxes.
There you have it. The cash basis and accrual basis are the two most common methods of accounting, each with its own advantages and disadvantages. It’s important to weigh the pros and cons before deciding which method is right for you. Talk to your accountant or tax advisor to get their professional opinion.
Do you need more information? Contact us today and we can help you figure out the best way to account for your taxes.