Whether cash or accrual broker accounting is better for your business impacts more than just how you report taxes
Key Takeaways
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Cash accounting accounts for transactions when the cash exchanges hands.
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Accrual accounting accounts for transactions when income is earned or expenses are incurred.
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Most brokers can choose which method they want to use.
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Brokers with average annual revenue of over $5 million may be required to use the accrual method.
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You can choose which method to use when filing your first tax return, but you must continue to use that method for future years.
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The IRS requires additional paperwork if you want to switch accounting methods.
Broker accounting can be complicated and time-consuming, but you need to track the numbers carefully to stay compliant with tax regulations and keep an eye on your company’s financial situation.
Accounting is more than just entering income and expenses into a spreadsheet or accounting software. Different accounting methods actually dictate the timing of when you should enter your income and expenses, like the accrual and cash methods.
This guide looks at accrual and cash accounting, explains when brokers are required to use each method, and goes over the pros and cons so you can decide which option is right for your real estate business.
What is cash accounting?
Cash accounting is considered to be the easiest, most straightforward option. Most businesses, including brokers, typically use cash accounting in the first few years of operating their business. This accounting method has you enter income and expenses when the cash exchanges hands.
You enter income when your client cuts you a check or pays you cash, and similarly, you account for expenses when you pay for them.
What is accrual accounting?
Accrual-based accounting doesn’t focus on when cash exchanges hands. Instead, it requires you to account for income when it’s earned and expenses when they are incurred.
Here’s an example. Say that you pay $1200 for a year’s worth of insurance. Cash-based accounting has you record the $1200 as an expense the day you cut the check, but with accrual-based accounting, you don’t record the expense until it is actually incurred.
Your insurance premiums are $100 per month, and in this situation, you record the $100 expense every month as you incur the expense, even though you paid for the insurance upfront. You also note income when you draft an invoice or complete the work, even if your client hasn’t paid you yet.
Are you required to use the cash or accrual method?
Anyone can choose to use the accrual method, but in some cases, the IRS may require your business to use the accrual method. The rules are slightly complicated, and the requirements vary based on the following factors:
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Average revenue over the last three years: Businesses that have average revenue under $1 million per year over the last three years are allowed to use the cash method of accounting. This rule applies regardless of the type of business you have. If you have been in business less than three years, you should use the average revenue for the time you’ve been in business.
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Services or products: Businesses that sell products typically must use the accrual method if their average annual revenue exceeds $1 million. This rule doesn’t apply to broker accounting as real estate brokers are service-based businesses.
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Business structure: Brokers that run their businesses as sole proprietorships, S-corporations, limited liability companies (LLCs), or partnerships can use the cash method regardless of their average annual revenue. C-corporations, in contrast, must use the accrual method of broker accounting if their average annual revenue exceeds $5 million.
Most brokers are allowed to use the cash method when filing their tax returns, and again, anyone can opt to use accrual-based accounting if they like. You must use the accrual method, however, if your average annual revenue exceeds $5 million and your business is a C-corp.
Differences between cash and accrual broker accounting
Those are the basic differences between cash and accrual methods, but you need to consider the logistics of each of these accounting methods and how the timing of recording your income and expenses affects your records. Here is how accrual and cash accounting stand up in three critical categories:
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Recordkeeping: Cash accounting tends to be easier than accrual accounting. You don’t have to enter invoices or bills if you opt to use cash accounting. You can simply enter expenses and income in the transaction registration of your accounting software.
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Cash flow tracking: Cash accounting makes it easier to track your cash flow. Your accounting records tend to be very close to your cash flow statements because you are actually entering income and expenses as the funds enter or leave your bank account. Brokers who use the accrual basis will need to do extra work to estimate their cash flow.
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Reflection of business performance: Cash accounting can distort your business’s performance on paper. Imagine you do a lot of work for a client in February, but you don’t get paid until May. Your cash accounting records show that you didn’t earn much money in February, but they show a lot of earnings in May. This doesn’t reflect what actually happened.
Accrual accounting, in contrast, lets you record when you earned the money, and as a result, this accounting method correctly reflects that February was a very profitable month for you. The accrual method tends to provide a clearer picture of how your business is doing.
You may want to experiment with both methods to see which one you like better. You can use the accrual method on your accounting records but cash for your tax return if you want to take a blended approach.
Make your selection carefully. You can choose between accrual and cash broker accounting when you file the first tax return for your business as long as you meet the revenue requirements explained above. You then have to continue to file your tax return using the same method, and if you want to switch in a future year, you will need to file additional paperwork with the IRS.
Contact Franco Blueprint for help with broker accounting
Deciding which broker accounting method to use is just the first step. You also have to set up your accounting software and ensure that you’re maximizing its potential. We can help.
Franco Blueprint offers training and assistance with broker accounting software, and we also offer help with company formation and CFO services. Contact us at Franco Blueprint today to learn more about how we can help your business thrive financially.