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OFFICIAL MAGAZINE OF THE NATIONAL ASSOCIATION OF REALTORS®



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   Choosing the Right Accounting Method

There are three basic accounting methods—cash, accrual, and hybrid—and each has its strengths and weaknesses. Choose an approach that gives you the information you need to analyze your results for each reporting period and to make informed cash-flow projections.

The cash method recognizes revenues and expenses at the time a cash payment is made or received. Income is credited and expenses are charged on the actual transaction date. For example, if the commission on a $150,000 house was $10,500, this income amount would be entered on the books on the day the check was received from the title company, lender, etc. If ads were purchased to sell the house, the $500 spent would be recorded as an expense when the check was written to the newspaper.

Pros
· Simple and requires few records.
· More realistic because it works with actual cash received rather than promises of future cash (receivables).
· Income tax is paid only on cash received.

Cons
· May not show cause and effect—an expense could be recorded in one period and the resulting income recorded at a later date, making it difficult to analyze your business’s profitability.
· Monthly expenses could be distorted if yearly taxes or other infrequent expenses are paid in a single month.

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· Small businesses that don’t deal in receivables or payables and service businesses that have slow receivables could use the cash accounting method to avoid paying taxes on revenue they haven’t received.

The accrual method (also called the accounts receivable/accounts payable method) recognizes revenues and expenses not when a payment is made or received, but at the time a service is performed or goods are delivered. If the commission on a $150,000 house was $10,500, that income amount would show on the books the day the house is considered sold—either when the contract is signed or when the deal closes. If ads were purchased at $500, the amount would be recorded as an expense on the date the advertising was placed.

Pros
· Shows exactly where the company stands each month in terms of income earned and expenses incurred.
· Prepaid, or infrequent, expenses can be spread out over several reporting periods.

Cons
· Taxes may have to be paid before cash is received.
· Data could become distorted if significant amounts of earned income aren’t collected or any recorded expenses aren't paid.

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Although the accrual method involves more bookkeeping than the cash method, it gives a better measure of profitability and a more accurate picture of a business's financial operations. It is the method required under generally accepted accounting principles.

Some businesses use a hybrid method. A service business, such as a real estate brokerage, could report income on the cash basis to minimize taxes but keep internal records on the accrual basis to have an accurate picture of profitability. However, you can only use one accounting method for income tax purposes.

Portions adapted from Financial Planning and Management, Course 502, Council of Real Estate Brokerage Managers, 2001

TIP: The IRS says businesses have to choose an accounting method that clearly reflects their income and use that method consistently from year to year. Once you choose an accounting method, you need written approval from the IRS to change it.

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