Small businesses typically fall into two different accounting methods: cash and accrual. Both accounting methods refer to the basic rules and guidelines under which businesses keep their books and prepare their financial reports.
Depending on the legal form of the business, sales volume, extensions of credit to customers, inventory, and tax requirements set forth by the IRS, small business owners need to decide which accounting method to follow.
While some form of record-keeping is required by law, the resulting information can also be useful in assessing the financial health of a business. Although it is possible to change accounting methods down the line, the process can become complicated. That being said, it’s important for small business owners to consult with an accountant early on to decide which method is best suited for their particular situation.
Cash Basis Accounting
If you follow cash basis accounting, your records recognize income and expenses according to cash flow. Income is recorded upon actual receipt of the funds; expenses are recorded as they are paid.
Using the cash basis accounting method, you are able to defer taxable income by delaying billing so that payment is not received in the current year. At the same time, you have the choice to accelerate expenses by paying them off in advance of the stated due date.
Accrual Basis Accounting
A small business using the accrual basis accounting method records income and expenses at the time they are earned or incurred, regardless of when the actual transactions are completed.
Using the accrual basis accounting method, revenue is recorded when a product or service is purchased rather than when payment is received; expenses are also recorded when they are incurred.
Cash vs. Accrual Methods of Accounting
The key difference between the two methods of accounting has to do with record-keeping and timing. Depending on the method used, a small business account may look very different at different points of the year; however, over time, the differences will diminish if all revenues and expenditures are accounted for properly.
Advantages of Cash Basis Accounting
For small businesses, the cash basis method offers several advantages:
- It's simple.
- It provides a real-time picture of cash flow.
- Income is not subject to taxation until payment is received.
One challenge with the cash basis method is that revenues and expenses are not always matched for a project within the same time frame. As you incur expenses for a project, say for employee time, you may not see the corresponding income until a later date.
Advantages of Accrual Basis Accounting
Unlike the cash method, accrual basis accounting recognizes expenses and revenue in the same time period for specific projects. As a result, a small business can tie records together, which provides a more accurate forecast of financial health.
However, the accrual method of accounting is more complex, and income taxes can be owed before payment is actually received.
So which accounting method is right for your business?
From a tax standpoint, the accrual method must be used is your business falls under the following criteria:
- Your business is a C corporation.
- Your business has inventory.
- Your gross sales revenue is greater than $5 million (there are some exceptions to this rule that you should discuss with your tax accountant).
Otherwise, you’re free to choose which accounting methods works best for your small business. For certain businesses, it’s advantageous to report taxes on a cash basis. Nevertheless, don’t rule out the option to use the accrual method as it may provide better insight from a management perspective throughout the year.
For more insight on using cash vs. accrual methods of accounting, contact our team. We’d be happy to provide you with a free, in-person consultation to discuss what is best for your small business.