Cash vs. Accrual Accounting for your Business

When you start working with a new accountant or even when you purchase a new software for your growing business, one of the questions you will be asked is “Which Accounting Method are you using.” While there are a few accounting methods per the IRS, the most utilized methods by small businesses are Cash, Accrual, or a hybrid of the two.

What does this mean for your business? 

Well, the cash method is exactly what it sounds like – Business transactions are posted in the system when cash is exchanged. Therefore, income is recorded when it is received, and expenses are recorded when they are paid. An example of this would be that a sale is posted when you receive a check from your customer or that an expense is posted when you pay a vendor in cash.

The accrual method on the other hand seeks to match revenue and expenses to the period they relate to. You would record an account receivable and sales revenue when it is earned, regardless of when the payment is received. Similarly, you would record an account payable and expense when an expense is incurred, regardless of when the cash payment is made.

A hybrid method can be implemented which combines the cash and accrual methods. With the hybrid method, you can use accrual accounting to account for your inventory only and the cash method to account for your income and expenses.

What are the advantages and disadvantages of the cash method?

The cash method’s main advantage is that it makes it simple to maintain cash accounting records. You don’t need to hire someone to do your accounting, you can do it yourself. You pay taxes on cash you received that year.  And because transactions are reported based on cash exchanged, it gives you the most accurate picture of your cash inflows and outflows.

The cash method’s major disadvantage is that it does not accurately reflect your company’s true financial position because it doesn’t match revenue to the period it was earned and expenses to the period they were incurred. It also doesn’t conform the US GAAP (Generally Accepted Accounting Principles). So, if you change your business structure later, you will also need to change your accounting method to accrual.

What are the advantages and disadvantages of the accrual method?

The accrual method’s major advantage is that it matches revenue to the period earned and expenses to the period they are incurred. Therefore, it gives you a very accurate picture of how your company is performing. And it conforms to US GAAP, so your numbers can be used to prepare US GAAP financial statements with minimal adjustment.

The accrual method’s main disadvantage is that it complicates your bookkeeping and you will need to hire an accountant to review your books and reports. It ignores cash flows, meaning that while your business may be extremely profitable, your bank account might be empty! For that reason, you will also need to monitor your cash flows.

Are there any rules to consider?

If you are a service-based business (no inventory), you can use the cash basis if your gross receipts are $1 million or less for a sole proprietorship and $5 million or less for partnerships and C-corporations.

If you offer credit to your customers or they pay you later for purchases, or if you make purchases on credit, you must use accrual.

Businesses that hold inventory for sale must use the accrual method. However, if the inventory is not a significant part of your business, you can use a hybrid method which allows you to use accrual to account for inventory only, and the cash method for everything else.

The IRS provides information regarding these methods on their website www.irs.gov, in publication 538 and Publication 334. Contact your tax accountant for more information to help you make this important decision. This decision has tax implications and you cannot easily switch between methods. Since a change would be considered a Change in Accounting Method, it would require the filing of Form 3115.  Therefore, the key is to choose a method and use it consistently.

If you are looking for help with the accrual method, please know that I come from a corporate accounting and auditing background, so I have considerable experience with it and use accrual for my own business. I look forward to hearing from you!

Disclaimer: This information is provided for informational purposes only. I am NOT an attorney and I am NOT YOUR accountant. The information provided does NOT constitute legal, tax, accounting or any other type of professional advice. Please consult with your own attorney or tax professional. We assume no liability or responsibility for any errors or omissions or reliance on this information.