Cash vs Accrual Accounting: What Every Small Business Needs to Know
What is the best method for a small business owner to manage the finances of their company? A solid business plan and an innovative idea will be the engines of your success, but good accounting practices are the key to ensuring the entire company functions effectively. That raises a key question: what’s the right type of accounting for a small business?
It may not be immediately obvious which of the two major choices, cash basis and accrual basis accounting, is the right choice for your small business needs. “Crunching the numbers” isn’t typically any small business owner’s favorite task, but its critical importance is difficult to overstate. Opting for the best fit for your need means looking beyond your immediate circumstances to consider the future of the business. The choice you make about accounting today will have important effects later on in the life of your business.
In this article, we’ll examine the fundamental differences between these two most common accounting methods before diving deeper into the benefits and drawbacks businesses encounter with each one. While some companies will legally have to use the accrual basis — more on that below — small business owners just starting out have an important choice to make. Explore these facts, consider their impact on your business today and tomorrow, and make an informed decision about the best way to structure your accounting for success.
What is the Difference Between Cash Basis Accounting and the Accrual Basis?
The different accounting methods a business can choose from vary based on the timing and methods used to express how the company takes in and spends money. Cash basis and accrual basis accounting use very different methodologies to track income and spending. As a result, a business can only rely on one or the other. Although it is possible to switch between different accounting methods later, it can be a difficult, time-consuming process — and in some cases, the law won’t allow you to make any such changes.
So, what marks these two as different? A cash basis method is exactly what it sounds like: you record changes on your ledger if and only if money actually changes hands. When a client pays an invoice, you record the cash for the month it changed hands — even if you issued the invoice in a prior month. This is in contrast to accrual accounting, which records transactions on the day they originate rather than their completion date. This slight but important difference has a major impact on how businesses operate.
Now let’s take a closer look at each accounting method and consider the benefits and the drawbacks they can offer to small business owners and operators.
What is Cash Basis Accounting?
As mentioned, cash basis accounting is a method of tracking business earnings and expenses that involves making records only upon the actual sending or receiving of a payment. In other words, cash basis accounting does not account for income you expect to have in the future. Functionally, that income does not exist to your business unless and until the business receives the cash in hand. Likewise, future expenses aren’t recorded but instead subtracted from your balances when you pay your obligations.
Because of its similarity to personal finances, operating on a cash basis is a simple, straightforward process for most businesses. That makes it an appealing choice for new small businesses, sole proprietorships, and businesses that intend to deal primarily in cash transactions (for example, a food truck).
The Pros and Cons of Cash Basis Accounting
|Simple and straightforward|
Record cash when you receive it and when you spend it — it’s as easy as that. Cash accounting is excellent for small businesses that want to keep operations lean and for those who do not have complex companies to run.
|Poor visibility for future obligations
Because you only record expenses when you pay them, the impact of future financial obligations is not always easy to recognize. On paper, those obligations don’t yet exist—which could lead to situations where you incur expenses but don’t have enough cash on hand.
|Opportunities to maximize tax advantages|
Because you don’t record income until you receive it, it’s possible to lower your tax burden with careful timing of payments and management of year-end expenses.
|Does not conform to GAAP
The IRS and most banks do not see cash basis accounting as part of generally accepted accounting principles. For certain kinds of businesses, that eliminates cash accounting as a potential option.
|Quick cash-flow snapshots|
It isn’t hard to know exactly how much cash the business has in the bank and how much money comes in and out of the business. The cash basis offers an honest picture of your company’s performance in the moment.
|A less accurate picture of business health
A good sense of cash flow is one thing, but how is your business performing over time? Looking to the future is not as simple with cash accounting. Past due accounts and late payments can become bigger issues due to poor visibility.
|Less complicated ledgers and accounting entries|
The single-entry system is simple to learn for most small business owners. Cash basis books are not very complex and, when well-maintained, can prove very reliable.
|Restricted access to capital
Because cash accounting is not GAAP compliant, institutional lenders and investors may not offer loans or other funding.
|Fewer accounting-related expenses|
Without a complicated double-entry system that requires frequent reconciliation, you may be able to keep accounting entirely in-house with your own skills.
|More opportunities for error
Very precise tracking of cash is important, especially when filing taxes. Even with a simpler accounting system, there are opportunities for human error. If not caught quickly, these issues can cause long-running problems in balancing the books.
|Difficult to transition
Should your business reach the threshold that requires accrual basis accounting, making the transition can be time-consuming, expensive, and frustrating — especially since you’ll need to file the IRS form 3115.
What is Accrual Method Accounting?
Since cash accounting is all about when you really exchange funds, it is easy to see that accrual does the opposite. A business using this accounting method maintains both accounts receivable and accounts payable. These track what the business owes and what others owe the business based on the time of the work or the transaction. Consider a firm that invoices a client for $10,000 in March. That client may have up to 90 days to pay the invoice — but the business records the credit in March upon issuing the invoice. Likewise, when that same business makes an agreement to pay a company later, it accounts for that expense in advance.
Accrual accounting is a recognized part of the GAAP standards or the “generally accepted accounting practices.” For some types of businesses, accrual accounting is not optional — it’s practically a requirement. In the US, the Internal Revenue Service sets forth several scenarios in which an accrual accounting basis is required for tax, such as a corporation with more than $27 million in gross receipts or one that keeps an inventory.
The Pros and Cons of Accrual Basis Accounting
Businesses can use the accrual basis for accounting, knowing that their practices meet the most widely accepted standards in the business world. Businesses can even transition from cash to an accrual basis by filing a specific form with the IRS, making it an accessible option when needed.
|More complicated out of the box
The double-entry accounting system has a learning curve that even established business owners find challenging. For new entrepreneurs and small business owners, it can be a major hurdle to overcome.
|Built for scale|
Cash accounting becomes a stressful, complex affair as operations grow. Accrual accounting continues to be an effective solution whether you’re doing $25,000 or $25 million in revenue every year.
|May require assistance from professional accountants
Because of double-entry complexity, a business may need outside help to support good accounting practices. This additional expense can have benefits of its own, but it is still an expense.
|Improved long-term visibility and understanding|
By recording credits and debits at their origin, businesses using the accrual basis can see the current health of the business and how its performance varies over time.
|May incur taxes before revenue occurs
When you record accounts receivable, you may owe tax on that income — even if it hasn’t actually occurred yet. This factor increases the importance of long-term planning.
|Offers strategic planning opportunities|
Because the business will have a better sense of its obligations over the long term, especially with recurring expenses, there are more opportunities to make financial plans to boost revenue and maximize profits through smart accounting and money management practices.
|More paperwork and more resources
There are multiple elements to track with accrual accounting, not only accounts receivable and accounts payable, but other factors too.
|No future concerns about changing accounting methods|
No matter how much your business grows or changes, you won’t need to make a complicated switch.
|Bookkeeping errors can compound problems
Human errors introduced into the accounts payable process can lead to missed or late payments that upset vendors. Likewise, poor oversight of receivables can let important payments slip through the gaps.
Choosing the Right Option for Your Small Business
Neither option is necessarily superior to the other, especially for small businesses. However, that does not mean that both solutions are an equally good fit for every company. On the contrary, some companies may struggle to stay on top of their numbers with cash or accrual accounting. At other times, there is no choice — the accrual basis is the only option. So how can a business owner make a smart choice?
Let’s start by examining cash accounting. This method is best suited for new small businesses and is especially acceptable for sole proprietorships. When your company only does a few tens or even hundreds of thousands of dollars in business, there’s no need to over-complicate matters. Many companies with only one or a few employees operate successfully on the cash basis throughout the company’s lifespan. So long as you’re aware of the potential drawbacks, it can work well.
What about the accrual basis? Any of the aforementioned businesses could still benefit from this method. More importantly, however, are considerations related to GAAP. Does your business hold an inventory or keep many assets on its books? Do you employ large numbers of staff, or have you surpassed the revenue threshold of $27 million? You’ll need to stick with the accrual method — not just for the sake of compliance, but for access to capital, better business health, and all of the other benefits it confers.
In some cases, a hybrid option is available — combining the use of the cash basis for tax calculations with the accrual basis for actual daily operations. Keep in mind, though, that the IRS has an array of rules that apply to hybrid accounting practices that go beyond those for either option individually. If you run the numbers and determine that this method could offer significant benefits to your business, make sure you partner with a certified accountant to validate your plans.
For some businesses, especially those with big long-term growth targets, investing in an accrual basis accounting setup early on can pay dividends in the future. However, it is also evident that the cash basis has many benefits for the small business owner. The $25 million revenue requirement that makes accrual accounting mandatory is a lofty goal — especially for local businesses that may not realistically achieve such numbers. Ultimately, the choice is in your hands. Consider the big picture, consult with an accountant, and make the most favorable for your business.