Cash vs Accrual Accounting

Regardless of the size of a business, it is crucial to implement an accounting process as early as possible. One of the fundamental decisions that small business owners must make is deciding which accounting method is right for them. Let’s explore your options.

Cash Method:

Cash basis accounting is the most straight forward and it’s popular among small businesses and sole proprietors because of its simplicity. With cash basis accounting, you record revenue when money comes in and expenses when money goes out. Let’s say you performed a service for a client on the March 18th, but the client sends the payment on April 10th. Under the cash basis, you would record that income on April 10th.

Accrual Method:

Under accrual basis accounting, revenue is recorded when it is earned, and expenses are recorded when they are incurred, regardless of when money comes in or out of your bank account. Let’s use the same scenario as the example above. If you performed a service for a client on the March 18th, but the client sends the payment on April 10th, that revenue would be recorded on March 18th, when the service was performed and therefore the revenue was earned.

As you can see from the examples above, the accrual method could be a bit more complex, but could offer some benefits depending on the size of your business. Before we get into the pros and cons, it is important to first understand when a business MUST use the accrual basis.

Inventory carrying businesses: In most cases, the IRS requires companies who carry inventory to use the accrual basis. There are some exceptions for small businesses.

Large businesses: GAAP (Generally Accepted Accounting Principles) requires publicly traded companies and businesses with average revenues of $25 million over the last three years to use the accrual basis.

Benefits of the cash method:

·        Simplicity: cash basis requires less time, is cheaper to maintain, and requires less knowledge of accounting. Simply track cash coming in and out of your business. No need to track receivables and payables.

·        Income tax planning: since you can have some influence on when money comes in and out of your business, the cash basis allows for more flexibility when you record revenues and expenses and could allow you to plan for tax season. For example, you can delay sending a December invoice to a client until January, so the cash comes in the following year, and isn’t included in your taxable income for the current year. You can also shift short-term expenses to the current year, which increases your deductions.

Benefits of the accrual method:

·        Gives a more accurate financial picture: because income and expenses are recorded when earned and incurred, the financial statements of a business will reflect all transactions that have already happened, regardless of when the money comes in or out of the business. GAAP and the IRS usually require large businesses to use the accrual method because as more people are dependent on a company’s financials to make decisions, those financials should paint a better picture than what the cash method can offer. Also, large businesses are more likely to have a large amount of fixed assets and long-term liabilities.

·        Makes it easier to plan: when you can see receivables on your financials, it becomes easier to budget because you are aware of the money you will have coming in the near future. Similarly, seeing liabilities on your books will give you time to prepare for that cash outflow.

 Modified Cash Method:

I can’t send you on your way without telling you about a hybrid accounting method that is also available, called the modified cash method. This method is right for businesses who don’t want the expense and complexity that comes from maintaining accrual books but would like to have a more accurate financial picture of their business. Under the modified cash basis, businesses can track their simple recurring expenses as they would under the cash method, and their long-term liabilities and fixed asset depreciation would be tracked using the accrual method. For some businesses, this method can be the best of both worlds.

What now?

The pros and cons will depend on the necessities of your specific business and industry. This is when it comes in handy to have an expert like Clear Books in your corner to guide you through this initial decision. Remember that the IRS requires that you maintain the accounting method consistent year-to-year, so it’s important to think about this as a long-term decision. However, you can apply for a change in accounting method using IRS Form 3115 Application for Change in Accounting Method.