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November 1, 2023 | 5 minute read
When it’s time to choose an accounting method, small business owners are faced with two approaches — cash-basis and accrual-basis accounting. Here’s a look at how they work, their advantages and disadvantages, and how to select the right one for your business.
With cash-basis accounting, the company generally records transactions when it receives payments from customers and pays vendors and other third parties. Another way to look at it: You only recognize income when it’s in or out of the bank. As a result, you don’t have to account for sales made on credit until customers pay you, and you don’t have to account for expenses until you pay them. This method doesn’t use accounts receivable or accounts payable in determining income. For federal income tax purposes, gross income includes all items of income you actually or constructively received during the tax year. Generally, only smaller entities are eligible to use the cash method of accounting.
Accrual-basis accounting generally recognizes revenue and expenses when revenue is earned and expenses are incurred, and not based on whether you’ve received or made a payment. This method records revenue and expenses you have earned or incurred and reflects your contractual right or contractual obligation to receive or pay in the future, and it is not only dependent on the current exchange of consideration. What’s more, it complies with Generally Accepted Accounting Principles (GAAP), a set of business and accounting standards from the Financial Accounting Standards Board, which publicly traded companies or those filing with the Security and Exchange Commission are required to use.
Cash-basis accounting is the simpler of the two options. It’s easier to track money as it moves in and out of your bank accounts, and there is no need to evaluate receivables and payables for determining income. Plus, you can get a realistic picture of your cash position, and you generally only pay taxes on income you have actually received.
On the other hand, cash-basis accounting provides a limited picture of business performance because the method generally only recognizes income and expenses when money flows in and out of your accounts instead of when transactions occur (i.e., when you may have a right to income or you have accrued expenses). That can make planning much trickier. Also, the cash method doesn’t comply with GAAP, so it’s a good idea to ask if your lender accepts this method before you choose this option.
In addition to being a requirement for GAAP and thus for publicly traded companies, accrual-basis accounting provides more complete information on a company’s financial position and results of operations. The methodology also helps you get an accurate reading of your business finances and a better grasp of long-term trends. Plus, it may help you keep track of a more complete record of each customer’s transactions.
However, accrual-basis accounting can also be time consuming and complex, with considerably more bookkeeping required to track not just cash but also receivables, accounts payable and other matters to determine income. It can also mask cash flow problems, making the business seem more profitable than it is, potentially leading to a cash crunch. Plus, accrual-basis accounting can leave you with unexpected tax bills if you are not paying close attention because its method for recognizing income may not align with when cash is received.
For most businesses with investors or lenders, the decision is easy. You may have to follow GAAP rules and use accrual-basis accounting for both tax and financial reporting. (The same is true for publicly traded companies.) However, certain small businesses — corporations or partnerships with average annual gross receipts of $25 million (adjusted for inflation) or less for the past three years ending before the current tax year — can generally use the cash method for federal income tax purposes. Other restrictions for using the cash method may apply.
A key factor in choosing a method is whether you use cash payments for transactions, for either sales or expenses. In that case, cash-basis accounting may be the right choice, though you’ll need to ensure there are processes for tracking outstanding payments. But if you rely on credit, either for your customers or your own bills, accrual-basis accounting may provide a more accurate financial picture.
Switching from accrual-basis to cash-basis accounting is helpful for businesses that want to immediately recognize revenue and expenses in line with cash receipts. It’s also a more simplistic approach. On the other hand, small businesses that opt for cash-basis accounting to take advantage of its simplicity may need to change their method as they expand and invest in other assets.
Be aware of tax rules. If you want to switch from accrual-basis to cash-basis accounting or vice versa, you’ll need to file Form 3115 with the IRS during the taxable year in which you want to make the change. Depending on certain circumstances, the IRS may approve the change in accounting method.
Ultimately, understanding both cash-basis and accrual-basis accounting will help you pinpoint the right method for your company. It will give you access to the data you need for smart financial decision-making, the cornerstone of any small business.
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