When you start to keep financial records for your business, you’ll need to decide what method of accounting to use. There are two choices – the cash method (also known as cash basis accounting) and the accrual method (accrual basis accounting). The IRS requires certain businesses to use the accrual method, including ones with $5 million or more in annual sales. But most small businesses are free to choose their preferred method of accounting.
In this blog post, we’ll outline the differences between these two accounting methods and what to consider when deciding which method is best for your business.
Using the cash method of accounting, revenue and expenses are recorded when the money is received or paid – not when the transaction takes place. Let’s say you send an invoice for $5,000 in July and get paid in September. You’ll record the $5,000 of revenue in your books in September since that was when the funds were received.
Many small businesses with simple operations use the cash method of accounting. It makes for simple and efficient recordkeeping since there is no need to track accounts receivable and accounts payable. You can also determine exactly how much money your business has at any given time without needing to first reconcile your books against your bank statement.
With the accrual method of accounting, revenue and expenses are recorded when the transaction occurs – not when the cash is received or paid. This means you record your income when it’s earned in your accounts receivable and your expenses when they’re billed in your accounts payable. You’ll come back and update your records again when the funds are paid or received and the transaction is complete.
Let’s revisit the $5,000 invoice example from earlier. Under the accrual method of accounting, you record the $5,000 as “accounts receivable” for your company in July, when the transaction took place and the invoice was generated. When the $5,000 actually makes it into your bank account in September, you’ll record a reduction to your accounts receivable because the payment was received.
The accrual method of accounting is far more common than the cash method. Even though it’s more complex and requires more time and effort to maintain, it provides a more complete picture of a business’s financial situation.
By keeping track of who owes you what and what you owe, you can make more strategic business decisions. Instead of making decisions based on your current bank account balance, you can consult your accounting records and see what you’ll be taking in and paying out in the future.
The tax differences between cash and accrual accounting
One major difference between cash and accrual accounting is revenue and expenses can get recorded in different tax years depending on which method you use. That means under the accrual method, you could end up paying income tax for revenue you haven’t yet received. Additionally, any expenses you incur but don’t pay during the year cannot be claimed on your taxes.
Should you use the cash or accrual method?
Both the cash method and accrual method of accounting have their advantages and disadvantages. If your business is a small and simple operation, you can get away with keeping basic records using the cash method. It is easier to manage and doesn’t cause tax complications. However, it doesn’t provide insight into your cashflow.
The accrual method provides an extensive overview of your business’s financial situation but requires more time and effort over the course of the year.
Some businesses choose accounting software that helps them use the accrual method or they employ bookkeeping professionals. It is generally a good idea to use the accrual method since cashflow is one of the best indicators of a business’s financial health.