Are you a small business owner just setting up your bookkeeping? You need to decide what type of accounting method you want to use to organize your finances: cash basis or accrual basis.
Cash and accrual basis accounting are the two methods used by bookkeepers, accountants, and small business owners (like yourself!) to keep their financial statements straight.
Cash basis accounting tends to be the “go-to” method for small businesses who are just starting out, mainly because it offers the most accurate depiction of your current finances. Meanwhile, accrual basis accounting is best for small business owners that want gain the most accurate understanding of how their business is performing.
Choosing the right accounting method for your business can affect everything from financial reporting to tax filing and needs to be thoughtfully considered. Especially because once you choose a method, the IRS expects you to stick with it. So what’s the difference between the two, and how do you choose the right one for your small business?
Cash basis accounting is what every “Joe Shmoe” uses for their bookkeeping. It’s the easiest method of accounting because it tracks income when it enters and exits your accounts. In the same way your personal checking account notifies you when money is actually added and subtracted, your business can operate the same way.
For example, you own a car repair shop and just did some repairs for Susan on her minivan last week. You sent her an invoice for $700 that must be paid in the next 30 days. You wouldn’t record that revenue in your financial statements until her payment hits your account in full.
Operating as a cash basis business gives you a solid idea of what your cash flow currently is, and how much cash you have at any given moment.
Pros & Cons of Cash Basis
Knowing your immediate cash flow and having a snapshot of your short-term finances are both solid reasons to side with cash basis accounting. But this doesn’t always paint an accurate picture of how your business is doing in the grand scheme of things.
The biggest downfall is that you have an inaccurate picture of long-term business tendencies.
For instance, you own a wedding planning business and just spent all of June planning your biggest wedding of the year. However, Jim and Kirsten don’t finish their payments until September when the wedding is a success. As a result, your June’s bookkeeping might look grim while September appears to be your biggest grossing month of the year.
One big perk? This simplifies tax season significantly when you’re only paying taxes on the money you already have for the year.
Accrual Basis Accounting
Accrual basis accounting is a method that records revenue and expenses when they occur, not when the cash physically changes hands. This method is generally a lot more accurate but requires a greater knowledge of accounting. Which means it’s less likely to be the “go-to” for small organizations.
Let’s say you own an irrigation company. You completed a $250,000 irrigation system for a beautiful new shopping outlet in October. The cost of materials and labor required to finish this project cost you $200,000. The client has been billed but won’t pay you until January.
In reality, you’ve profited $50,000 from this job, and if you’re using accrual basis accounting then your financial statements will accurately depict this even though you haven’t been paid. Had you been using cash basis, then your October books would reflect a loss of $200,000 in expenses, rather than a $50,000 true profit.
See how this can get tricky?
Pros & Cons of Accrual Basis
Though accrual basis accounting doesn’t measure cash in hand, one of its strengths is that it focuses on what you really earned vs. what you owed in any given period.
This gives you a better understanding of your overall profitability and gives shareholders, investors, and banks an idea of how you perform over time.
While operating on an accrual basis is usually a better option, you’ll need to keep close tabs on your accounts and actual cash flow. Otherwise, you can end up spending money you don’t have yet…which can come back to bite you.
What are the IRS requirements?
In the US, accounting is expected to follow GAAP to make financial records digestible and uniformed. Most small businesses can operate using cash basis accounting, but the IRS has some rules (as they do about most things).
For starters, if your small business holds any type of inventory, you don’t have any other choice than to operate on an accrual basis to record purchases and sales. There are options for a hybrid method though.
The IRS allows you to use different methods when filing taxes than you use for personal financial tracking. You can file taxes on an accrual basis, but can record things like rent, and interest on income on a cash basis. (The best of both worlds!)
Note that if you are a C Corporation making more than $5 million a year, you’re also locked into the accrual-based method.
What’s the right accounting method for your small business?
If you operate a small business where cash receipts and the related expense payments occur at the same time (or close to the same time) then a cash basis method could work just fine. It’s simple, easy to use, and can save you time.
However, accrual method is best for you if:
- You have inventory.
- You’ve paid upfront for a service but need to distribute it over the months you’ll use it.
- Your clients pay you in advance for work you haven’t done yet.
- You may need financing from the bank in the future.
- You want more accurate financial statements.
Make the right accounting decisions for your small business.
Both accrual and cash basis accounting have their pros and their cons. When choosing what method is right for you, choose wisely — because you’ll be sticking to this method for a while.
If you’re not an expert, the next best plan is to give your books to an accountant who can handle all of your numbers for you. Contact Know Your Numbers PLLC today and we’ll be happy to advise you about what method of accounting might be right for your small business.
Do you prefer one method of accounting over the other? Be sure to drop your thoughts below!