Accounting For Startups – How To Lower Your Tax Liability
Written by Baixue Ma, Tax Lead, airCFO
As a startup founder, you know cash flow is the lifeblood for your business. But did you know that the accounting method you choose can have a significant impact on cash flow and tax liability?
In this article, we share how startup founders can significantly reduce their tax liability by converting from accrual accounting to cash basis accounting.
- The difference between cash accounting and accrual accounting
- Who can use this conversion (and who can’t)
- How to get help, if you need it
Cash Accounting vs Accrual Accounting
Cash accounting, also known as cash-basis accounting, is an accounting method where payments are recorded when they are received, and expenses are recorded when they are actually paid.
Accrual accounting, on the other hand, recognizes revenue when it’s earned and expenses when they are billed (but not paid).
Which Method Should You Use?
Small businesses often use cash accounting because it is simple and straightforward and provides a clear picture on how much cash the business actually has on hand. However, accrual accounting can help you better leverage your cash position and maximise your operational abilities by spreading your revenue recognition and receivables.
For some companies, it can be financially advantageous to consider using both methods. For instance, depending on your business structure and stage, you may use accrual-based accounting for ongoing financial analysis, but choose to convert the books to a cash-basis for IRS and tax purposes if it lowers your tax liability.
Having said that, depending on your startup’s stage and structure, you may be required to use the accrual method. For example, you are required to use accrual accounting if your startup has gross receipts greater than $25M in the tax year.
Not sure which method you could – or should – use? We can help. Book a complementary call here and let’s talk about it.
How To Convert Your Accrual Accounting to Cash Accounting
To convert your journal entries from accrual basis to to cash basis, follow two steps:
#1 – Roll Retained Earnings
To start, make sure the prior year ending retained earnings balance on your balance sheet is the same as the current year beginning retained earnings balance.
#2 – Convert Entries from Accrual to Cash Basis
Next, convert your journal entries from accrual basis to cash basis, where applicable. For most cases, you will only need to convert the following:
- Accounts Receivable (AR)
- Accounts Payable (AP)
- Accrued expenses
See It In Action
To illustrate, let’s assume you’re preparing your taxes, with the tax year ending December 31, and you are converting your books from the accrual basis method to the cash basis method for the first time.
Using accrual based accounting your trial balance shows:
Year 1 – Accrual Based Trial Balance
Now let’s look at these same numbers, converted to cash-based accounting
Year 1 – Accrual-to-Cash Journal Entries
|Accounts Payable||10||Tax Expense||10|
|Accrued Expenses||5||Insurance Expenses||5|
The biggest benefit from these journal entries is reversing sales income of $50, deferring the recognition into Year 2.
Now let’s look at Year 2. Remember to check if your retained earnings are rolling on an accrual basis first.
Year 2 – Accrual Based Trial Balance
Year 2 – Calendar Year Accrual-to-Cash Journal Entries
Again, the biggest benefit from these journal entries is reversing sales income of $240, deferring the recognition into Year 3.
Now that we’ve done this conversion, we have a second step for accrual to cash journal entries: reversing all the prior year accrual to cash journal entries to recognize the entries as revenue or expense, because in theory cash should have been received or paid in Year 2.
So now, we make these additional journal entries:
Year 1 – Accrual-to-Cash Journal Entries
|Retained Earnings||12||Rent Expense||12|
|Tax Expense||10||Retained Earnings||10|
|Insurance Expense||5||Retained Earnings||5|
With the knowledge now in-hand about cash and accrual accounting, we’d challenge founders to think which is best for them at their current stage. Still have questions about what accounting method is best for your startup at it’s current stage or how changing your accounting method might effect your tax liability? Feel free to reach out and schedule a discovery conversation here.
Author Note: Baixue leads up the tax team at airCFO. She is a CPA with extensive experience advising startups, and previously worked in a regional CPA firm and a Big 4.