The difference between cash-basis accounting and accrual-basis accounting is straightforward: It comes down to when you record sales and purchases in your accounts. However, each accounting method has pros and cons, and one may be better for your business than the other. For instance, many small businesses start with a simple cash-basis accounting method, but as they evolve, they may need more insight into their financial health to facilitate growth.
As a business owner, how do you know which small business accounting method is best for your business and when it’s time to make the switch? Keep reading for ways to answer these questions.
What is cash-basis accounting?
Cash-basis accounting is the simpler of the two financial accounting methods; small or early-stage businesses often favor it. This accounting method records the company’s cash inflows and outflows and then reconciles.
In other words, the business records revenue when cash is received and expenses when payments are made. This simple method has no integrated record of accounts receivable or accounts payable; that information is generally recorded separately.
Pros and cons of cash-basis accounting
If you’re considering cash-basis accounting for your business, you should understand its benefits and disadvantages.
These are some of the pros of cash-basis accounting:
- Cash-basis accounting is easy. Cash basis is the simpler accounting method, as it requires you to track less information. This method is easier for business owners to learn, use and operate.
- Cash-basis accounting lets you see the “here and now.” Cash-basis accounting deals only with concrete funds, so it’s easier to see how much money is on hand. You don’t need to factor in future expenses and income.
- Cash-basis accounting has potential tax advantages. Cash-basis accounting lets you control the transaction timing. Speeding up expenses and slowing down revenue can sometimes decrease a company’s tax liability.
These are some of the cons of cash-basis accounting:
- Cash-basis accounting offers a limited view of finances. Cash-basis accounting provides a great financial snapshot but doesn’t show the complete picture. It doesn’t factor in potential business or customer liabilities, which could also affect decision-making.
- Cash-basis accounting has restricted use. Not everyone can use cash-basis accounting. Businesses that offer credit to customers, rely on inventory, or have gross receipts higher than the IRS requirements must use accrual accounting.
- It may be difficult to switch from cash-basis accounting to accrual-basis accounting. If your business changes from cash-basis to accrual-basis accounting, you must make adjustments when transitioning your books. You will also have to contact the IRS.
Startups often operate with cash-basis accounting because it provides more information about their ability to generate a positive cash flow statement.
What is accrual-basis accounting?
Accrual-basis accounting is a more advanced way to handle business accounting. This method accounts for all transactions when they occur; it more accurately reports a company’s financial results instead of cash on hand.
For example, you record the associated revenue when you close a sale, not when your customer pays the invoice. You document expenses when your company receives goods or services instead of when you pay the invoice.
Accrual-basis accounting provides a clearer, more dynamic financial picture of what’s happening in your business.
The accounting cycle in accrual-basis accounting requires year-end journal-entry adjustments to record expenses that have been incurred but not yet paid, like rent, interest and inventory bought on credit.
Pros and cons of accrual-basis accounting
Accrual-basis accounting also has potential advantages and disadvantages.
These are some of the pros of accrual-basis accounting:
- Accrual-basis accounting provides consistency. If expenses and revenue are always recorded at the point of sale, future financial planning is more manageable. Looking at cash on hand at any given moment doesn’t provide an accurate depiction of the average activity your company is experiencing or what your future inflows or outflows will be.
- Accrual-basis accounting offers greater financial opportunities. When you apply for business loans, banks and other lenders usually prefer you use the accrual method of accounting.
- Accrual-basis accounting offers better analysis. When you can align your revenue and expenses within given time frames, you can better analyze how much profit your company has gained.
These are some of the cons of accrual-basis accounting:
- Accrual-basis accounting is more challenging. Accrual-basis accounting is more complicated, so it can lead to unintentional errors — or, worse, deceptive practices such as hiding accounting mistakes in financial reports.
- Accrual-basis accounting has staffing requirements. With a more complicated method and required monthly reports, businesses often need an accounting and finance team (or even an entire department) to successfully manage accrual accounting.
- Accrual-basis accounting has potential tax disadvantages. While accrual-basis accounting allows your business to report income as soon as you make a sale, it also requires you to pay taxes on money you haven’t yet received.
Generally Accepted Accounting Principles (GAAP) rules require accrual-basis accounting and abide by the principles of revenue recognition and expense matching.
Is cash- or accrual-basis accounting best for my business?
To understand which business accounting method best fits your company, you must determine your company’s current standing and goals. Start by asking yourself the following questions:
1. Is my company required to use the accrual method for tax purposes?
These are some types of companies that are required to use the accrual method for tax compliance:
- Companies with inventory or goods
- C corporations
- Companies with more than $5 million in gross sales revenue (this is not cut-and-dry; talk with a tax consultant to determine if you fall into this category)
2. Who needs to know my company’s financial information?
If only a few internal managers examine your financial information for relatively straightforward decision-making, the cash method may be appropriate. However, when making decisions, management will be limited to the financial information available.
In cases where external stakeholders must be privy to your company’s financial information (such as angel investors, banks and advisors), you will want to utilize the accrual accounting method. The accrual method will provide insight into your company’s financial shape and show external stakeholders that the business has the financial savvy to grow.
The best accounting software can help you stay in compliance whether you’re using cash- or accrual-based accounting.
3. Where do I want my company to be in five years?
If you’re happy with your current number of transactions and don’t foresee much growth for your business, the cash-basis method could be the right fit. However, if you have a business growth plan to advance your company beyond its current revenues — particularly if you think that revenue will rise above $5 million — it’s best to implement the accrual method as soon as possible.
The accrual method will provide a better picture of your company’s financial results, allowing your internal and external stakeholders to better analyze operations, make more informed decisions, and grow the business.
Transitioning from cash to accrual accounting
Transitioning from cash to accrual accounting can be daunting, especially if your internal accounting resources are limited. In these instances, it may be worth hiring a CPA or seeking guidance from an outsourced accounting team. They can facilitate the transition and provide the ongoing accounting support and financial analysis necessary for you to effectively run your company, analyze your operations, and guide your business decisions.
Jennifer Dublino contributed to the reporting and writing in this article.