When starting a small business, the owner often needs to determine if they want to keep their business books on the cash or accrual basis. Some businesses are required to use the accrual method (per the IRS) but a large majority of small businesses have the choice of either cash or accrual which requires at least a basic understanding of the differences between the two methods.
Cash is the easiest method to use but may not provide an accurate picture of your business. You see, the cash method only accounts for income when it is received and expenses when they are paid. So if you have customers who pays you this month for products/services provided in a previous month your business will look more profitable this month since that is when you received their payment. Likewise, if you pay vendors for products/services received in previous months your business will look less profitable this month since that’s when you paid their invoices.
Accrual is more difficult to use but provides a more accurate picture of your business. With accrual, you recognize the income when it is earned – not received and you recognize expenses when they are incurred – not when they are paid. Let’s look at an example to illustrate.
Your customer pays you $10,000 immediately for the services provided however, you don’t pay your vendor the $5,000 in supplies you used to do the above work until the following month. On a cash basis, your financials would reflect a profit of $10,000 this month and a loss of $5,000 next month when you pay your vendor. Again, it’s cash in and cash out. However, using accrual you would show the $10,000 income AND the $5,000 owed to your vendors even though you have not paid them. This results in a profit of $5,000 this month and $0 profit the next month even though you paid your vendor.
Either way, the results are the same – the business profited $5,000. However, the financial statements for those two months are going to tell a very different story. Which method do you think gives the owner a more accurate view of the business?
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 Quickbooks users need to understand that financial reports produced in Quickbooks on the accrual basis without the use of adjusting entries are likely not truly accrual.
When hiring individuals it can be difficult to know whether you are hiring an employee or an independent contractor. Many business owners would like to consider them an independent contractor in order to save money:
- The business owner is not required to pay any employment taxes on the monies paid to the individual. These taxes include social security, Medicare, FUTA, and SUI.
- The business owner is not required to provide workers’ compensation insurance which, depending on the class code, can be quite costly.
- The business owner does not have to provide the benefits provided to their employees such as vacation and sick time, medical insurance, 401K contributions, etc.
- It reduces the number of FTE employees on their payroll. This could help the employer prevent being considered a “large employer” under the provisions of the Affordable Care Act.
Tempting isn’t it? But misclassifying an employee as an independent contractor can be a very costly mistake resulting in significant fines, penalties, payment of all uncollected income and employment taxes and possible prosecution.
Generally speaking individuals who are in an independent trade, business or profession in which they offer their services to the general public are considered independent contractors. However, there are other factors that need to be considered as well:
- Behavioral Control which addresses training, instruction, when/where/how the work is performed, and the evaluation system.
- Financial Control addresses investments, expenses, opportunity to profit or loss, services available on the open market and method of payment.
- Nature of the Relationship addresses contracts or absence thereof, benefits, permanency of the relationship and level of services vital to the business.
If after considering all the above and the business owner is still unsure, they can have the IRS make the determination for them. (However, it can take the IRS 6 months to respond.)
I encourage you to visit irs.gov and learn the rules or call our office for help!
Until next time…
As you know, the IRS adds, modifies or eliminates tax laws on a frequent basis. Keeping you current with such news is the purpose of this page. I recommend that you bookmark this page and check back on a regular basis. Thanks, ~ Kim
Interest Rates Remain the Same for the First Quarter of 2012
The Internal Revenue Service today announced that interest rates will remain the same for the calendar quarter beginning Jan. 1, 2012. The rates will be:
- three (3) percent for overpayments [two (2) percent in the case of a corporation];
- three (3) percent for underpayments;
- five (5) percent for large corporate underpayments; and
- one-half (0.5) percent for the portion of a corporate overpayment exceeding $10,000.
The 3 percent rate also applies to estimated tax underpayments for the first calendar quarter in 2012 and for the first 15 days in April 2012. Read the rest of this story here…