Cash vs. Accrual Accounting: What’s Best for Your Small Business?
As a small business owner, choosing between the cash basis method of accounting and the accrual basis method of accounting to track revenues and expenses is one of the most important financial decisions you have to make. The difference between cash basis and accrual basis is the timing of when transactions are recorded in your books. If you use the cash basis, you recognize transactions when cash is exchanged. If, on the other hand, you use the accrual basis, you recognize transactions when the service is performed or the expense is incurred, regardless of when cash is exchanged. Business owners can choose between the cash basis or the accrual basis as long as revenues are below a certain threshold set by the IRS, the business doesn’t maintain inventory or offer credit to customers, and the company is not publicly traded. Otherwise, you are required to use the accrual basis method of accounting. While each method of accounting has its pros and cons, choosing which method is right for you depends on the type of business you have, the size of your business, the resources available to you, and your business goals.
Cash Basis Accounting:
Cash basis accounting records revenue and expenses when cash is exchanged. In other words, cash basis accounting only records revenue when money is received from a customer and records expenses when money leaves the company’s bank account to pay suppliers, vendors, and other third parties. This method is mainly used by small businesses and sole proprietors. The main benefit of using cash basis accounting is how simple it is as it requires less effort in bookkeeping. With cash basis accounting, it is easier to see how much cash your business has on hand at any given time. In addition, it is easier to prepare tax returns because it is based on actual cash received during the year. However, cash basis accounting does not take into consideration revenues you have earned for which you have yet to receive a payment for, or expenses you have incurred but not yet paid. As a result, your finances may not be accurate until cash has been exchanged. Moreover, banks, creditors, and other financial stakeholders may not accept financial statements prepared using the cash basis and may require the use of the accrual basis instead.
Accrual Basis Accounting:
Accrual basis accounting records revenue and expenses as they are earned or incurred, regardless of when cash is exchanged. Under the accrual method, revenue is recognized in the income statement when earned. If the company has yet to receive the payment from the customer, a receivable is recorded in the balance sheet. The receivable remains in the balance sheet until the payment is received. Similarly, expenses incurred by the company but not yet paid are recognized in the income statement and a liability is recorded in a balance sheet account until the payment is made. Note that under the accrual method, cash did not have to exchange hands for the transaction to be recorded. The accrual method is more complicated and requires a reasonable knowledge of accounting principles. However, using the accrual method provides a more accurate picture of your company’s profitability and financial health. This also makes it easier to budget, forecast, and make other important business decisions. Lastly, the accrual method complies with U.S. Generally Accepted Accounting Principles (GAAP) and is the preferred method for creditors and investors.
If you are having difficulty in choosing between the two accounting methods or would like the benefits of the accrual basis but are not sure if you have the resources needed, CPA by Choice is here to help. We’ll manage your books, prepare your financial statements, and even handle tax filing. We are available to answer your questions, feel free to call us or send us a message.