For most contractors, the decision to use the cash or accrual method is not a simple decision, but it’s one of the first significant decisions about the business they’ll make.
Cash vs. Accrual
Cash basis. Income is recorded as it is received and expenses as they’re paid. This method does not take into account any accounts receivable or payable. Many contractors choose the cash basis of accounting because bookkeeping is simple. It’s easy to track money as it moves in and out of your bank account and you don’t have to pay income tax on revenues until the money is actually in your possession.
The downside to the cash basis of accounting is that it can produce an inaccurate overall picture of your company’s finances.
Accrual basis. Income and expenses are recorded when they are billed and earned, regardless of when the money actually changes hands. The upside to the accrual basis of accounting is that it gives the business owner a more realistic picture of how the business is doing. The drawback is that it doesn’t account for cash flow – your books could show healthy revenues while your bank account is empty.
Accounting for Long-Term Contracts
The two most common approaches to accounting for long-term contracts are the percentage-of-completion method and the completed contract method.
Percentage-of-completion method. Income is reported in accordance with the percentage of the contract that is completed during the year. This is calculated by comparing expenses incurred for the project during the year with estimated total contract costs.
Completed contract method. Income is not reported until the contract is complete, even though the contractor may receive payments in years prior to completion.
For contractors, the options for accounting for revenues and expenses are more varied than those available to many other businesses and the choice can have a significant impact on tax liabilities not just in the current year, but over the life of your business. As a business owner, it’s a good idea to discuss the decision with your tax advisor to ensure you’re making the most informed decision.
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ABOUT THE AUTHOR
Senior Staff Accountant
Alex is a Senior Staff Accountant with Brown Schultz Sheridan & Fritz. He specializes in providing audit services to for-profit organizations across various industries.