Are you a new business owner? Or is your business quickly growing and your accounting and operations needs changing? Either way, you will need to consider which accounting method is best for your company: cash basis vs. accrual basis accounting.
First, it’s typically best to choose and stick with one accounting method. However, if you started off using cash basis accounting, you may need to switch to accrual accounting down the road – this often happens with small businesses as they grow. Note that if you do decide to switch accounting methods, you need to get permission from the IRS to make a change.
So, what is cash basis accounting and accrual accounting? And how do you know which is best for your business? We’re answering all that and more below.
What is Cash Basis Accounting?
In cash basis accounting, you would recognize income and expenses when received or paid. Simply put, it’s a cash in, cash out recording method.
Ok, but what are the tax implications of cash basis accounting? Say you performed work in December 2021, but the client didn’t pay you until January 2022. In this case, you would report the income on your 2022 tax return – when you receive the money.
Cash earnings include:
Credit card payments
Revenue from clients
Pros of Cash Based Accounting
Allows for easy recordkeeping: This is a tangible and straightforward method, making it easy to track. Your accounting software automatically records and categorizes all of your income and expenses. All transactions are essentially pulled from your bank statement.
Reflects your actual cash flow: Cash basis accounting shows all cash coming in and out of your business, so you have a clear understanding of your business’s cash position and how it changes over time.
Cons of Cash Based Accounting
Not a comprehensive picture of your business: On the other hand, cash basis accounting doesn’t give a clear idea of your profitability. This can make it more difficult to make significant business decisions because you don’t have the details you need. It can also be challenging to budget and forecast, as you have no line of sight on your company’s overall historical performance.
Hard to track receivables and payables: Since you don’t record transactions until you receive income or pay the bills, it’s harder to keep track of things. You have to have cash flow records and separate reporting for your accounts receivable and accounts payable.
No insight into your fixed assets: Inventory and fixed assets are essential to know for your taxes because you can receive tax benefits, but with a cash basis, you can’t track non-cash expenses like depreciation and amortization.
When to Use Cash-based Accounting
Cash basis accounting may be best if you are a:
Small business startup
Solo and budding entrepreneurs often choose cash basis accounting because:
It requires less of a learning curve and is less time-consuming.
They can manage it themselves, which is ideal for those who can’t yet afford an accountant.
It helps you see and manage cash flow for your small business taxes (i.e., If a client is late paying you for a service or product they bought before the filing deadline, you could report the expense on the current year’s taxes but wouldn’t have to report the income until next year.)
What is Accrual Basis Accounting?
With accrual basis accounting, you recognize the revenue or expense when it’s incurred, not when the cash exchanges hands.
For example, if a contractor receives payment on February 28th to install a door on March 1st, he recognizes the revenue in March when the job is completed.
Pros of Accrual Based Accounting
Gives a comprehensive picture of your business: Accrual accounting shows your company’s performance and profitability, helping you to make more appropriate business decisions. It also equips you for better forecasting and budgeting and ensures you don’t overcommit to expenses.
Investors and lenders want to see it: If you use accrual accounting, you’ll have a better chance of securing financing and funding when you do intend to grow. Not to mention, accrual is the GAAP-accepted method, which applies if you expand your business and end up going public.
Cons of Accrual Based Accounting
Requires more time and energy: More complex, requires additional operational components (e.g., inventory management, AR system, fixed assets tracking, etc.), so will require more staffing and effort and a more complex accounting system.
Harder to spot cash flow problems: Accruals can make your income statement look better than it is. You may not have the cash to substantiate the profit on your income statement. You’ll need to view your profit and loss alongside your cash flow statement.
When to Use Accrual Accounting
Your small business grosses $25 million or more over a three-year period: The IRS requires businesses that make $25 million or more over the last three tax years to file accrual basis tax returns.
You have inventory: To understand your business's complete performance and profitability, you need to track inventory – which you can only do with accrual accounting.
Your state requires you to file sales tax: If you live in a state like New York that requires businesses to file sales tax returns on an accrual basis, you need to use accrual accounting. This ensures that you have the proper accounts receivable and collection processes in place. Your accountant can help you determine if this applies to you.
More Small Business Accounting Methods
Now that you understand the difference between cash basis and accrual accounting let’s review a few other accounting methods you may need to consider depending on your business.
Percentage of Completion
This is a work-in-progress accounting method typically used by construction companies and other contractors. It recognizes the revenues and expenses of long-term contracts on a period-by-period basis. In a nine-month contract, you might complete 20% of the work in the first three months and 40% of the work after the next three months. You would only recognize 20% of the revenue in those second three months.
This method allows companies to defer expenses and revenue until after a contract is completed. With this technique, you would not recognize income and expenses on your income statement even if cash payments were issued or received during the contract period. This is another method commonly used among construction companies and other project-based industries.
The high-low method involves separating fixed and variable costs with limited data by comparing the costs of the highest and lowest levels of activity. High-low is often used to calculate the fixed and variable costs of a product, product line, equipment, store, geographic sales region, or subsidiary.
An asset’s cost basis is its purchase price adjusted for stock, dividends, and capital distributions. This calculation is used to determine the capital gain, which is the difference between the asset’s cost basis and current market value. For example, you may need to calculate an item’s capital gain for tax purposes.
Chances are, you will use either cash basis or accrual basis accounting in combination with some of these additional accounting methods. It all depends on the type of work and your business’s accounting and operations needs.
If you have more questions about which accounting method is best for your organization, let’s chat! Schedule a free consultation or call us at 603-541-7485 to speak with our experienced accounting team!