Most small businesses maintain their bookkeeping on a cash basis of accounting, recording revenue and expenses only when money flows in or out. By contrast, accrual accounting records revenue when earned and expenses when incurred. Cash basis is easier and provides a satisfactory financial picture if your business is generally paid promptly by customers and pays its bills immediately upon receipt. Nevertheless, some transactions are necessarily accounted for as accruals even by cash basis operations. These are most often amounts that will be remitted in the future for taxes.
For example, payroll taxes are expensed by a business on payroll dates, but remitted on future days. Payroll taxes that are deducted from employee pay are part of the company’s expense for wages, although the withheld amounts are not paid simultaneously with net paychecks. The employer part of payroll taxes is another expense category that’s also recorded on payday.
Because payroll taxes are remitted at a later date, recording the expense on payday is offset by an accrued liability on the balance sheet. If the taxes accrued for remittance in the future are not recorded on the balance sheet, the expense will not appear on the income statement. Profit is therefore overstated due to the missing expense.
When an accrued amount of payroll taxes is eventually remitted, it has no impact on the income statement because the expense has already been recorded. The remittance applies to the accrual on the balance sheet.
To assure accuracy of expenses, it is essential to constantly examine the accrued tax liabilities on your balance sheet. This close watch will help you avoid financial surprises.