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What Are Accrual Taxes?

Accrual taxes are based on the principle that income and expenses are recognized when they're earned or incurred, not when cash is exchanged. This method provides a more accurate financial picture, aligning tax obligations with actual economic activity. Curious about how this impacts your finances? Let's delve deeper into the world of accrual accounting and its implications for your tax strategy.
Sandi Johnson
Sandi Johnson

Tax laws and required accounting methods vary greatly, differing from one nation or region to the next. As such, any discussion of accrual taxes is subject to those differences. The primary concept of accrual, however, relies on timing, no matter the specific country's tax laws. In terms of taxes, accrual relates to the amount of taxes owed, based on income or asset values to date, whether or not those taxes are currently due or have been paid.

Most countries abide by two methods for determining and reporting income or asset values within a given tax period. Cash basis and accrual basis accounting, sometimes referred to by slightly different terms, use two different methods of recording a transaction. Which method of account recording an individual or organization uses determines income or asset growth and, subsequently, accrual taxes.

Businessman with a briefcase
Businessman with a briefcase

For example, the United States and many European nations require periodic tax payments throughout the tax year, once income or asset growth reaches a certain limit. How much an individual or organization owes each quarter or other tax reporting period is based on estimated accrued taxes. Those accrued taxes are based on how much income is reported for the period or how much an asset's value has increased. Determining the amount of income depends on whether the cash or accrual basis is used.

With cash basis, income and asset value increases are recorded as money is received or expenses paid. Accrual basis, on the other hand, records transactions as they occur, regardless of when the physical money changes hands. To illustrate the difference, consider an attorney and client relationship. Clients typically pay in advance for a portion of the expected services they request. After those monies are exhausted, the attorney sends periodic invoices for service rendered.

An invoice is sent to the client for services to represent him, covering past work the attorney has already provided. If cash basis is used, the income earned is not recorded on the attorney's books until the client pays the invoice. Alternatively, if accrual basis is used, the income is recorded when services are rendered and the invoice is sent. Each month, the attorney computes estimated or accrual taxes to date, based on the transactions recorded for that month. Such accrual taxes may not yet be payable, depending on specific local tax laws, but the amounts owed have begun to accrue.

Depending on specific tax laws, the use of cash or accrual basis accounting can greatly impact accrued taxes. Invoices sent and recorded using accrual basis may incur payable accrued taxes before payment of the invoice occurs. Large businesses can typically absorb such expenses without needing payment from the client, while small businesses and individuals rely on income to help cover expenses like accrual taxes.

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