Cash or Accrual Accounting – Considerations for the Lodging Industry

There are two basic accounting methods that you can use to record and report your financial transactions, the cash method, and the accrual method.  Although only the accrual method complies with Generally Accepted Accounting Principles (GAAP), businesses that do not carry inventory and have revenues of less than $25 million are free to use either method (see IRS Publication 538 for more details).

The Cash Method

 Revenue is recognized when payments are received from customers, and expense is recognized when payments are disbursed to vendors and suppliers.

Advantages of cash accounting:

  • Simple straightforward and easy to use, similar to how you might track your personal finances.  There is a direct correlation between net income and your bank account.
  • Best suited for small service-based companies that operate as sole proprietors or partnerships and do business through cash transactions. By this, we mean if you accept payment at the time of sale and pay expenses at the time they are incurred.  It can be a convenient and reliable way to track revenue and expenses without the need for a great deal of bookkeeping.
  • Tax perk:  IF you accept payment sometime after your customers depart, you may defer paying taxes until the tax period that you collect payment. 

Disadvantages of cash accounting:

  • If you sell gift certificates or take prepayments/advance deposits, the cash method will record revenue in an earlier period than the related expenses resulting in distorted net income.  This can give you a false sense of security that the business is doing well when, in fact, it may not.
  • Cash accounting does not require you to keep track of accounts receivable or accounts payable, which can create problems if you do not have strong controls in place to ensure you are fully collecting from all your customers and paying all bills in a timely manner.
  • Tax issue: IF you take prepayments/advance deposits, you are paying tax on those receipts in advance of earning the revenue.  You must manually calculate and remit the amount of sales and occupancy tax associated with each payment.
    • Similarly, if you refund any payments made towards a reservation, you will want to calculate a refund of tax remitted on that refund.

The Accrual Method

Revenue is recognized when it is earned (the business has provided goods or services as agreed upon), and expense is recognized when it is incurred (goods or services have been provided to the business as agreed upon).   Liability (e.g., Prepayments, Advance Deposits, Accounts Payable) and asset (e.g., Accounts Receivable) accounts are used to track the difference between the flow of money and the recognition of income and expenses. 

Advantages of accrual accounting:

  • Presents a more accurate financial picture by closely matching revenue with the related expenses in providing that revenue.  For example, variable expenses such as food, wages and payroll expenses, and utilities will likely fluctuate in a similar way to revenue throughout a year.  The result provides you with a better understanding of your business’s profitability in the high, low, and in-between seasons, allowing you to better plan each phase of your cycle.
  • Uses balance sheet accounts such as Accounts Receivable and Advance Deposits to keep track of monies due from your customers and payments you have received in advance.
  • The reports in ThinkReservations are aligned with the accrual method.
  • Tax perk:  Taxes are due based on the date the revenue is earned (when the guest stays with you).  If you take advance deposits, you have use of the money without having to pay the tax until the revenue is earned. 
  • Tax Perk: You do not have to calculate sales and occupancy taxes on payments received, or on refunds made. 

Disadvantages of accrual accounting:

  • More complex method which may require additional resources.
  • Tax issue:  If you take payment some time after the guest departs, you potentially will owe taxes before collecting payment.  

Another Option – A Hybrid Method

 In addition to the cash and accrual methods, the IRS allows special methods of accounting for certain items of income and expense, and a hybrid method which combines elements of 2 or more of the other accounting methods.  There are 2 stipulations:

  1. If you use the cash method for reporting income, you must use the cash method for reporting expenses, and
  2. If you use the accrual method for reporting expenses, you must use the accrual method for reporting income.

 You can, however, use the accrual method for reporting income and the cash method for reporting expenses.  If you are using the cash method of reporting income and expenses, here is why you may want to consider this hybrid method:

  • Assuming you pay your bills close to the time that the service is provided, you can experience the advantages of the accrual method mentioned above.
  • You can enjoy the convenience of reporting expenses when you pay them.

 

Disclaimer: ThinkReservations Support team members are not certified income tax or accounting professionals and cannot provide advice in these areas, outside of supporting questions about ThinkReservations. If you need income tax advice please contact an accountant in your area.

S
Sean is the author of this solution article.

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