Cash vs Accrual Accounting: Which One is Right for You?
Your accounting method matters. As a business owner, your choice will impact how and when you need to report expenses and revenue. You’ll need to make the decision between cash vs accrual accounting, and it’s one that is a double-edged sword:
- Cash is easier for most businesses
- Accrual offers a clearer view of your finances
And as you’ll see shortly, if you make over a certain revenue threshold annually, you may be required to use one of these methods for tax purposes.
It’s important to understand the difference between these accounting methods and which one is right for you.
What is Cash Basis Accounting?
Cash basis accounting is ideal for many small business owners who often prepare their own taxes and for the 64% who are doing their own bookkeeping. The idea of cash basis is simple. Transactions are recorded when:
- Payments are received
- Payments are “constructively” received
Expenses are also recorded when payments are made, even if that means you pay earlier than they’re due.
Example of Cash Basis Accounting
Constructively received payments work like this: You perform legal services for Jonathan and he hands you a check on January 25. You cash the check on February 5th, but you had control over the payment in January, which is when you would log the income.
Again, if you had to pay $1,000 to your business credit card on February 5th but paid on January 28th, you would record the payment in January.
What is the Accrual Method of Accounting?
Cash basis accounting is simple, but accrual accounting is more accurate. You record earnings when they’re earned and expenses when you incur them.
Example of the Accrual Method of Accounting
Using the previous example, let’s assume that you are a lawyer and perform all of the tasks necessary to be paid. You send the invoice to your client, and at this point, you’ve ticked all of the boxes for being paid.
You’ve fulfilled your duties and would record the income as accounts receivable at that point.
If you have to pay rent for your office space on the 1st of the month but it’s the 2nd of the month and you haven’t paid yet, it’d show up as an (overdue) accountant payable on your books.
Cash vs Accrual Accounting: Which One is Right for You?
Now that you understand the difference between cash vs accrual accounting, you may be wondering which one is right for your business.
The answer will depend on a few things, including:
How You Do Business
If you run a small business that does primarily cash transactions and doesn’t have a large inventory of products, the cash accounting method may make sense for you.
However, if you want a more accurate and complete picture of your business’s financial health, then the accrual method may be the better option.
The Complexity of Your Business
The complexity of your books and operations may make one accounting method more sustainable than the other.
For example, if you have multiple subsidiaries or hundreds of employees, cash basis accounting may not give you a complete picture of your business’s financial health. This accounting method does not reflect the income that’s been invoiced but not received yet. It also does not consider future expenses you’ll need to pay.
The more complex your business, the greater the likelihood you’ll need to use the accrual method of accounting.
Revenue and Entity Type
Depending on your entity type and revenue level, you may not have a choice in the type of accounting method you use.
- According to IRS rules, small businesses with average annual gross receipts of $26 million or more over the prior three years must use the accrual method of accounting. For tax years beginning in 2023, this threshold increases to $29 million.
- Publicly traded companies are obligated to provide an accurate picture of their financial health to shareholders. The accrual method of accounting is the best way to achieve this goal.
Ultimately, if you have a small company that primarily does cash transactions, the cash basis method may work well for you.
But for many companies, the accrual accounting method is the better choice simply because it gives you a bigger, clearer picture of your business’s financial well-being.
Deciding on which accounting method you should use can be confusing or overwhelming, but it’s a decision that should ideally be made early on or before you even launch your business.
Consider consulting with an accountant who can help you determine which method is ideal for your business now and in the future.To learn more about accounting methods or how we can help you with your accounting needs, schedule a consultation now!
