If you are a business owner, it is critical for you to understand the finances and operations of your business. All the financial documents and accounting reports for your business will serve different purposes and, therefore, will provide important information upon which you should base your business decisions. One of the most important distinctions will be to have an accrual or cash basis of accounting for your business.
Essentially, cash basis accounting only recognizes revenue and expenses when cash or money exchange hands, but the accrual method of accounting recognizes revenue once it has been earned and invoiced, instead of when cash is actually received. While neither choice is right or wrong, they both serve very different purposes and provide different information to the business owner. Learning about the accrual vs. cash basis of accounting will help you make the best decision regarding which type of accounting method your company should use.
Cash Basis Accounting
Cash basis accounting only recognizes income or revenue when cash is received into the company, and when expenses are paid. This type of accounting is simple to manage for small businesses since they only have to make an accounting on their financial statements when a transaction has occurred completely, meaning that the money has either come into or left the bank account. In this method of accounting, no tracking will be done of any account receivables (goods or services delivered but not yet paid for) or accounts payables (money due but not yet paid). This method of accounting will also make the cash flow statement significant as the basis upon which the accounting is performed for the company. Another significant benefit of this type of accounting is that a business’s income is not taxed until the money is actually in the company’s bank account. The downside to this method of accounting is that the company does not have an accurate picture of all the money that they are currently owed, or that they currently owe to others.
Accrual Method Accounting
Unlike the cash basis accounting method, the accrual method accounting method does not look at all at how much cash has been received or spent by a company. Rather, this accounting method will instead record earnings once a good or service has been delivered, sold, or invoiced, even if the money has not yet been paid for the good or service.
Additionally, if a business owes an expense, or has been invoiced, the amount that is owed by the company is also recorded in the accrual method whether it has actually been paid for by the company. The downside to this method of accounting is that the company does not have any awareness of how much cash is currently in its bank account available for use. Without a business owner being very intentional regarding their cash flow, they may face catastrophic financial consequences if they only rely on the accrual method of accounting.
Practical Example
Oftentimes, business owners feel overwhelmed regarding how to put accounting practices into practical use and how they should use the information they discover on their financial statements. Using an example can help you as a business owner decide what type of accounting method you should choose for your business.
Example
- Your company sold goods worth $10,000 and invoiced the recipient of these goods.
- Your company also received a $1,000 bill for some necessary equipment that you purchased this month.
- Your company paid $100 for an invoice you received last month for company purchases.
- Your company received $2,000 from a customer for goods delivered in the previous month.
Cash Basis
Using the cash basis method of accounting, you would take the $2,000 cash received minus the $100 you paid for company purchases, and your accounting spreadsheet would show that your company currently has $1,900 profit.
Accrual Method
Using the accrual basis method of accounting, you would take the $10,000 invoiced, minus the $1,000 bills you need to pay for equipment, and your accounting spreadsheet would show that your company currently has $9,000 profit.
As you can see, the difference between what your company shows as profit is quite different using the cash basis vs. the accrual method of accounting.
Taxes and Accounting Methods
One of the most important reasons behind choosing a method for accounting has to do with taxes. First, if your company is registered as a corporation (other than an S-corporation) and averages over $25 million in gross receipts every year, the Internal Revenue Service (IRS) requires that you use the accrual method of accounting.
However, for all other businesses, you still have a choice whether to use either the cash basis or accrual method for your company. Typically, if you are a small or new business, you may want to consider using the cash method, especially if you do not carry any inventory. This way, your business will only look at when you actually receive and spend cash, which can beneficial and an easier approach for small businesses. However, if you have any inventory with respect to your business, you should likely consider using the accrual method. If you ever need to change your accounting method, you must alert the IRS through Form 3115.
Payroll and Accounting Methods
If you are a business, you likely have employees, even if you are a small business. The accounting method that you choose will impact how you pay your employees and payroll taxes. If you choose the cash basis, you will record that you owe payroll taxes every time you write the payroll checks because that is when the taxes are officially paid. However, if you choose the accrual method, you only record the payroll taxes monthly or quarterly as you are required to pay them as a business owner. In this case, the accrual method of accounting is actually easier to manage because you only need to handle it once a month, or once a quarter, instead of weekly or even more often if you are using a cash basis of accounting.
Advantages and Disadvantages
There are advantages and disadvantages to both the cash method and the accrual method of accounting. Some of the most seen advantages and disadvantages that affect businesses are listed below.
Advantages and Disadvantages of the Cash Basis Method
Advantages
- The cash basis method is extremely simple to record since it only requires a business owner to record when cash is received or spent by the company.
- For taxes, the cash basis allows a company to avoid paying taxes on any money it has not yet received.
- Typically, a company that uses the cash basis method of accounting is less likely to be audited by the IRS.
Disadvantages
- If a company happens to have a large sum of cash recorded, it may inflate and misrepresent whether the company is profitable or not.
- The cash basis method does not provide as accurate of an overall picture of the profitability of a business, especially in relation to the long-term, because it does not incorporate accounts receivable or accounts payable in its recording.
- The cash basis method does not conform to the Generally Accepted Accounting Principles (GAAP). While this may not matter as a small business, if your company grows to over $25 million in revenue and is a corporation other than an S-corporation, you will need to switch your method of accounting to the accrual method.
Advantages and Disadvantages of the Accrual Method
Advantages
- The accrual method likely provides a more accurate representation of the profitability of a company, especially over time.
- The accrual method smooths out earnings because all income and expenses are recorded over time instead of being intermittently recorded in spurts, as is done in the cash method.
- The accrual method does conform to the Generally Accepted Accounting Principles (GAAP).
- Typically, this method of accounting lends itself to fewer errors, since it uses what is known as double-entry accounting. This type of accounting requires that every single business transaction is posted to at least two accounts and, in some cases, even more. This will keep the company’s books balanced and, while this is much more involved and time-consuming, it makes it much easier to find and correct any potential accounting errors.
Disadvantages
- The accrual method does not track the cash flow of a company, and the company may be facing a significant cash shortage without knowing it, even though they look profitable on paper.
- The accrual method is more difficult to implement and more complicated than the cash basis method of accounting. This method of accounting takes many more resources to accurately complete due to its complexity.
- A company may be more likely to be audited by the IRS if they use the accrual method of accounting.
- A company may have to pay taxes on income before the customer has actually paid their invoice. If this occurs, it is important to note that the company may claim the tax back on the next return.
Hybrid Method of Accounting
If you are a business owner, you may struggle with trying to decide between the cash basis or accrual method of accounting. You may want the ease of cash basis accounting but desire the more complete picture of your company finances provided by the accrual method of accounting. There is the option for you as a business owner to choose a hybrid method of accounting.
You may choose to use an accrual method of accounting for all the inventory of your company, and a cash basis of accounting for your income and expenses. This type of hybrid method will give you a unique picture and may be a good fit for your business. However, there are very special IRS rules that are required to be followed by companies choosing this hybrid method of accounting. Consulting with an experienced business attorney can help you understand if this method would be right for your small business.
Deciding on a Method of Accounting
If you are trying to decide which method of accounting to use for your business, you should consider several factors, including the following questions.
- Are you a small company or solo entrepreneur that does not need a great deal of financial analysis right now? (Cash basis)
- Do you believe your company will exceed $25 million in revenue in the near future? (Accrual method)
- Will you be selling your company at any point in the near future? (Accrual method)
- Are you interested in obtaining financing at any point? (Accrual method)
- Do you believe that your company will go public soon? (Accrual method)
- Do you have a great deal of inventory? (Accrual method)
- Are you a nonprofit organization? (Accrual method)
While these answers are not set in stone, they give you a good idea of where to start regarding the decision you need to make as a business owner. Different types of businesses will lend themselves to different types of accounting practices.
Contact Our Team of Experts
If you are starting a business or are just now considering the accounting side of your business, you may feel overwhelmed by the number of financial options that are available to you as a business owner. Deciding what type of accounting your business should use is a complicated decision and will impact how you look at your business from a financial perspective, as well as your day-to-day operations and how you pay taxes.
Our team of real estate and small business bookkeeping experts at Anderson Advisors welcome the opportunity to discuss the advantages and disadvantages of both the cash basis or the accrual method of accounting, and how each would impact your business. Call our bookkeeping specialists at 877.965.3751 or visit us online for a free consultation today.
