Business owners and operators manage their finances using two principle accounting methods: cash basis and/or accrual basis accounting. By default, most small businesses use the cash method, primarily because it requires less accounting knowledge and diligence to manage. The accrual method is typically required for publicly-traded companies, or for organizations who want or need to have their financial statements audited.
Deciding which method to use for a given business is also a matter of strategy, however, as each method can produce markedly different financial results and tax filing implications.
The cash accounting method recognizes revenue and expenses when cash changes hands. When cash enters a company’s bank account, for example, it is considered, and recorded as, revenue. When cash exits a company’s bank account, it is recorded as an expense. Cash basis accounting is often used because of its simplicity and low cost. Below, we have outlined the advantages and disadvantages of the cash method.
- Recording transactions using the cash basis is simple in nature and less time-intensive than the accrual method. Under the cash basis, you will likely spend less on outsourced bookkeeping, accounting and CPA services.
- The cash method gives an accurate account of cash on hand (i.e. cash flows), because revenues and expenses are only recorded when cash enters or exits the bank account. This makes for an easy-to-read financial statement and requires little explanation or interpretation of financial accounts.
- The recognition of revenue can be deferred to the accounting period when the cash is received, which can produce tax advantages for businesses that extend terms to their customers.
- Certain expenses can be paid for in advance and deducted from your revenue even if you receive the funds from your customers at a later date.
- If you run a business that receives cash from customers before it pays the associated expenses (a good example is a retailer that has extended terms with its suppliers), the taxes will be paid sooner and this could impact your cash flow.
- Tracking profitability within each accounting period is more difficult because revenue and expenses are not matched to the same period. A good example is your local lawn service - if they mow your lawn on September 30, but you don’t pay them until October 1 (assuming the lawn company paid their workers and fuel costs on the day of service), they have reported expenses in September and revenue in October. Under the accrual method, that revenue would have been recognized in September and therefore matched to the expenses.
- Management use reporting: it is usually better to use the accrual method for internal management use financial reports because you are matching revenue and expenses in the same period.
The accrual accounting method is a more time intensive method, but allows for better tracking of a company’s profitability. Using this method, the business records revenue when it is earned, or when a job is completed. The same goes for expenses - they are recorded when incurred, regardless of the timing of the payment. The emphasis on recording revenue and expenses when they are earned or incurred gives the business owner a more accurate record of financial results. Here are a few advantages and disadvantages:
- The accrual method enables a business to incur expenses for the current tax year by purchasing and receiving (not yet paying for) goods or material before the close of the year. This practice can dramatically impact the taxable income reported on the annual tax return
- The ability to track profitability from month to month is enhanced, because revenue and expenses are recorded when incurred
- Unlike the cash method, the accrual method makes it more difficult to get a clear picture of cash flows due to the timing of receipts from customers and payments to suppliers. The cash flow statement is very important to read and understand when you are operating your books on the accrual method
- Recording entries under this method is more complex (and time-consuming). Since the accrual method records transactions that have not yet taken place, it can be difficult or confusing to understand how to accurately account for your sales and associated expenses. This often requires advanced accounting expertise, additional staff, or the assistance of a CPA
Best choice for a small business
For most small businesses and sole proprietorships, the cash method is the more accessible option, as it allows for simpler tracking and recording of transactions (and thus is less time intensive and expensive). The cash method allows for a business to closely monitor cash flow which can be quite important when a business venture is first starting out.
Keep in mind that the IRS imposes regulations on when the cash method can be used. A given business, other than prohibited entities, must meet the gross receipts test in order to qualify to use the cash method on their tax return. In order to meet the gross receipt test an entity must have an average annual gross revenue of $25 million or less. If you are unsure of whether you qualify under the gross receipts test, it is a good idea to reach out to your tax advisor.
Choosing the ideal accounting method requires thoughtful consideration, but understanding the basic methodologies of each is a good first step towards making a wise choice for your business.
Interested in discussing the best approach for your business? Book a 30-minute call with me.