Four important considerations for every small business owner
A few years ago, a small business owner–we’ll call her “Sarah,”–found herself facing a hefty tax bill. She ran a growing online store and thought her finances were in good shape—until she sat down with her accountant. After reviewing her records, her accountant pointed out that if she’d used the cash accounting method instead of accrual, she could have reported less income that year and saved hundreds in taxes.
Sarah hadn’t realized that the way she tracked her sales and expenses could affect her tax bill so significantly, but it’s a fact–by making smart accounting decisions and sticking to them, you can minimize your taxable income.
In this post, we’ll walk through four key accounting decisions you should be aware of.
1. Cash vs. accrual
The first major decision you’ll need to make is whether to use cash accounting or accrual accounting. Here’s the difference:
- Cash Accounting is simple. You record income when you actually receive money and expenses when you actually pay them. This method can help you manage your cash flow because you only report income when it hits your bank account. If you’re looking to delay reporting income and lower your taxable income for the year, this method can help.
- Accrual Accounting is a bit more complicated. With this method, you record income when you earn it (even if you haven’t received the payment yet) and expenses when you incur them (even if you haven’t paid them yet). This method gives a clearer picture of your business’s overall performance but can result in higher taxable income in the short term since you’re reporting money you’ve earned even if it hasn’t arrived in your account.
Which method is right for you? If you have a smaller business with simple operations, cash accounting might be the easiest way to go. But if your business is growing or you want a more detailed picture of your finances, accrual accounting could be better in the long run.
2. Inventory
If your business sells products, how you handle your inventory can make a difference when it comes to taxes. When you buy goods to sell, you don’t have to expense them immediately—you can spread that cost out over time. But there are different ways to calculate the value of your inventory, and each method can affect your tax bill in different ways.
Here are the three main methods:
- FIFO (First-In, First-Out): This method assumes that the first items you bought are the first ones you sell. If prices are going up, this method can lead to higher profits (because you’re selling the cheaper items first), which means higher taxes.
- LIFO (Last-In, First-Out): This method assumes that the last items you bought are the first ones you sell. If prices are rising, this can lower your profits (because you’re selling the more expensive items first), and as a result, you could pay less in taxes.
- Average Cost: This method averages out the cost of your inventory. It’s a middle ground between FIFO and LIFO, and it can help stabilize your profits and taxes.
Choosing the right method will depend on your business’s needs and the costs of your products. If prices are going up and you want to lower your taxes, LIFO could be a good choice. But if you’re looking for simplicity or predictability, FIFO or average cost might be a better fit.
3. Long-term contracts
If your business takes on projects that span over a long time (like construction or consulting), you’ll need to decide how to account for those projects. These contracts can last months or even years, and you don’t want to report all the income at once—especially if you’re still working on the project. There are two ways you can handle long-term contracts:
- Completed contract method: With this method, you don’t report any income or expenses related to the project until it’s finished. This can be helpful if you want to delay income reporting and lower your tax bill in the short term. However, it can also mean that you have big swings in your income when the project is completed and reported.
- Percentage-of-completion method: This method allows you to report income and expenses gradually, as the project progresses. It’s a more balanced way of spreading out the tax impact over time, as it aligns with the work you’re actually doing.
If you’re working on long-term projects, it’s important to choose the method that helps smooth out your income and tax obligations, based on the timeline of your work.
4. Bad debts
Bad debts are the amounts your customers owe that you don’t expect to get paid. Every business runs into this issue at some point, and how you handle bad debts can impact your taxes. There are two ways to account for them:
- Direct write-off method: This method is simple: when you realize a debt is uncollectible, you write it off. The downside is that it can create sudden swings in your income and taxes, especially if you have large amounts of bad debt in a given year.
- Allowance method: Instead of waiting until a debt is written off, you estimate how much you expect to lose over time and set aside that amount as a reserve. This helps smooth out the impact on your income and taxes, because you’re spreading the loss over time.
If you deal with a lot of bad debts, the allowance method can help keep your financials stable and predictable.
Take control of your accounting methods
In the 1980s, Apple found itself facing rising inventory costs as it expanded rapidly. To help manage those costs and minimize its tax bill, the company decided to use the LIFO method for inventory accounting. This choice meant that Apple could recognize the costs of its newer, more expensive products first, which reduced the company’s profits on paper and, in turn, lowered its taxable income. Apple understood that this strategy would save them a significant amount in taxes, especially during a time of inflation. By the time the 1990s rolled around, this smart move helped Apple reinvest in innovation and scale its business even further. Apple’s story is a great reminder that accounting methods aren’t just about tracking money—they can also be a strategic tool to manage taxes and fuel business growth.
Even if your business isn’t the next Apple, you too can choose smart accounting methods to minimize your tax burden. The best way to take full control of your finances and ensure you’re making the most tax-efficient choices is by consulting with professionals. By working with tax professionals, you can avoid costly mistakes, optimize your accounting practices, and ultimately keep more of your hard-earned money in your business.