One of the first things you’ll have to decide when you start your business is whether you’d like to use cash vs. accrual accounting. Unless you’re an accountant, keeping track of your small business finances can feel like a whole new world. It’s important to understand both methods of accounting before making the choice.
So what’s the difference between cash and accrual accounting, and how do you know which is best for your business?
What’s the difference between cash and accrual accounting?
Both cash accounting and accrual accounting help you keep track of your income and expenses. Your small business accounting software most likely supports both types of accounting and leaves the choice up to you, but there are important differences you need to understand.
Using the cash accounting method means that your business records your income when it comes in and your expenses when they go out. For example, if you send an invoice to a customer in July but they don’t pay you until August, you wouldn’t record the income until you receive their payment. Similarly, you wouldn’t record a bill when you receive it, but instead, you would record the bill when you pay it.
With the accrual method, your income is recorded at whatever time happens earliest: a) when you earn it, b) when the amount is due to you, or c) when you earn the income. Your expenses are also recorded as you accrue them. Using the same example above, if you sent a customer an invoice in July, your books would show that income in July even though you didn’t actually receive the money until August. You also record your expenses as you accrue them, even if you haven’t paid them yet.
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Examples of cash vs. accrual accounting
Let’s look at an example to see how these two accounting differences might impact your bookkeeping.
Let’s say you’re a painting company and you made these transactions.
- In October, you spend $50 on the paint at a local paint store. You complete a job for a customer and charge them $5,000.
- In November, you do an additional job for the same customer. You spend $100 on paint, but you ordered it from a supplier and you don’t need to pay their invoice until December. You bill the customer $4,000 for the additional work.
- The customer pays you for both jobs in January.
Using the cash method, your books would look like this.
- October: Spent $50 on paint
- November: Nothing happened
- December: Paid supplier for $100 of paint
- January: Received $9,000 from your customer
Using the accrual method, your books would look like this:
- October: Spent $50 on paint and received $5,000 in income
- November: Spent $100 on paint and received $4,000 in income
- December: Nothing happened
- January: Nothing happened
In this example, the company using the cash method wouldn’t be liable for taxes on their income until January when they received the money from their customer. The company operating the accrual method would be liable for taxes when they did the work, even though they hadn’t yet received the payment from their customer.
Should your business use cash or accrual accounting?
Since accrual accounting is necessary to meet generally accepted accounting principles (GAAP) requirements, certain companies must use accrual accounting. IRS Publication 538 explains that some businesses are required to use accrual accounting, while others may choose to use the method they prefer.
Many small businesses can use the cash method of accounting. However, the IRS requires businesses that produce, sell, or purchase merchandise to keep inventory and use the accrual method for sales and purchases of merchandise.
The IRS also states that most corporations (other than S corporations), partnerships with a corporation as a partner, and tax shelters must use the accrual method. However, if the business had less than $26 million in average annual gross receipts for the past 3 years, they pass the “gross receipts test” and may use cash accounting.
Even if your business isn’t required to use accrual accounting, that doesn’t automatically mean that cash accounting is the best choice. There are a few items to consider before selecting the cash accounting method.
How quickly do you expect your business to grow? If you expect to meet the accrual method requirements in the next few years, it may be beneficial to use the accrual method now, even though it’s not required by the IRS.
If your business keeps an inventory, you may also need to use the accrual accounting method. Publication 538 offers more guidance, and you can also seek guidance from an accountant or tax professional to find out if this is required for your company.
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What are the pros and cons of cash and accrual accounting?
If your company can decide between the accounting methods, here are some things to think about before you make the decision.
Pros of using cash accounting
With the cash accounting method, the amount in your books should closely resemble the amount of cash you have in your bank account. This makes it easier to keep track of how much cash you have on hand and can help you ensure you can cover all your expenses as they arise. You also don’t pay taxes on your income until you get paid, which can be a big plus for smaller businesses that may not have large cash reserves yet.
Generally, this method is much simpler to learn and use than the accrual method. If you’re keeping your books yourself, this method is simple to learn even if you don’t have an accounting background. Using the cash accounting method could save you money since you may be able to keep your bookkeeping in-house.
Cons of using cash accounting
While the cash accounting method is simple to learn, one drawback is that it doesn’t provide your company with a picture of your accounts payable. Since you don’t record expenses until you pay them, it’s impossible to see what expenses you have coming up. This can create inaccuracy in your financial reports.
It also doesn’t show the full picture of your company. Some companies may have busier months where they send a lot of invoices out, but don’t get paid for 30-60 days. The cash accounting method doesn’t take your unpaid invoices into account when looking at the financial health of your company.
If your business eventually needs to change to the accrual method due to a change in your corporation status or company growth, you may find switching from the cash method to the accrual method to be a bit daunting as well. It will require a shift in your entire accounting process and may be an initial expense as far as staffing or even hiring out your bookkeeping to get it up-to-date for the accrual method.
Pros of accrual accounting
The accrual accounting method is more difficult to learn and implement than the cash accounting method. However, this method gives provides your company with a more accurate financial picture since it shows future transactions, including income you expect to receive and expenses you expect to pay.
The accrual method also complies with GAAP, while the cash accounting method does not.
Cons of accrual accounting
Since accrual accounting requires a deep knowledge of accounting practices, businesses using this method may spend more money on training employees or paying an accountant to handle their books. Cost and a steep learning curve can be one of the bigger downsides for companies trying to decide between cash or accrual accounting.
Another con is that your bank account balance may look far different from what your books show. Companies using accrual accounting need to keep a close eye on their cash to ensure they can cover all of their expenses. Companies can look great on paper but still struggle with cash flow issues as they await the payment of invoices.
Since your company accounts for income even if you haven’t actually received it, you may find that you incur taxes on payments you haven’t received yet. Again, you’ll need to keep a close eye on your available cash to make sure you can cover taxes and other liabilities.
Final thoughts on cash vs. accrual accounting methods
The IRS may require your business to use the accrual accounting method. If you aren’t required to use accrual, you can choose whether to use the cash accounting method or the accrual accounting method. While it’s an important choice, you should know you can also change your mind. If you decide to switch between accounting methods, you’ll need to use IRS Form 3115 to let the IRS know about the change.
There are pros and cons to both types of accounting methods, and every business has different needs which may make one method preferable over the other. If you’re still not sure which method you should use, you can ask your accountant or another financial advisor which method is best for your business and your future goals. See what software small businesses must have and choose the software that suits your business best
Do you have more questions about how to choose between the cash accounting method or the accrual accounting method? Ask us in the comments, we’ll be happy to help!