There are a couple methods of analysis you can use to determine the financial health of your business. But which is best?
The difference between cash-basis accounting and accrual-basis accounting is really rather simple: It comes down to when sales and purchases are recorded in your accounts. However, each accounting method has its 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 better insight into their financial health to facilitate growth.
As a business owner, how do you know which accounting method is best for your business and when it's time to make the switch? Keep reading for ways to best answer these questions.
What is cash-basis accounting?
This is the simpler of the two accounting methods, so it is often favored by small or early-stage businesses. With this accounting method, the company's cash inflows and outflows are recorded and then reconciled.
To put it another way, revenue is recorded when cash is received, and expenses are recorded when payments are made. With this simple method, there is no integrated record of accounts receivable or accounts payable; that information is generally recorded separately. [Read related article: The Pros and Cons of Hiring a Bookkeeper]
Pros and cons of cash-basis accounting
If you're considering using cash-basis accounting for your business, you should understand the pros and cons that come with it.
Pros of cash-basis accounting
Ease of use: Cash basis is the simpler method of accounting and requires less information to be tracked. This makes it easier for business owners to learn, use and keep up with.
Ability to see the "here and now": Cash-basis accounting deals only with concrete funds, so it's easier to see how much money is actually on hand. You don't need to factor in future expenses and income.
- Potential tax advantages: Cash-basis accounting allows you to control the timing of transactions. Speeding up expenses and slowing down revenue can decrease a company's tax liability in certain cases.
Cons of cash-basis accounting
Limited view of finances: Cash-basis accounting provides a great financial snapshot, but it doesn't show the full picture. It doesn't factor in potential business or customer liabilities, which could also impact decision-making.
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.
- Potential difficulty of switching to accrual: If your business changes from cash-basis to accrual-basis accounting, you will need to make adjustments when transitioning your books. You will also have to contact the IRS.
What is accrual-basis accounting?
This is a more advanced way to handle business accounting. With this method, all transactions are accounted for when the transaction occurs or is earned to more accurately report on your company's financial results, rather than the actual cash on hand.
For example, you record the associated revenue when you make a sale – not when your customer pays the invoice. The same is true for expenses, which are documented when your company receives goods or services, rather than when an invoice is actually paid. This method of accounting provides a clearer, more dynamic financial picture of what's happening in your business.
Pros and cons of accrual-basis accounting
Accrual-basis accounting also has its potential advantages and disadvantages.
Pros of accrual-basis accounting
Consistency: If expenses and revenue are always recorded at the point of sale, it makes future financial planning easier. Just looking at the cash on hand in any given moment does not provide an accurate depiction of the average activity your company is experiencing or what your future inflows or outflows will be.
Greater financial opportunity: Banks and other lenders usually want to see the accrual method of accounting for companies before deciding whether to extend a loan.
- Better analysis: When you can align your revenue and expenses within given timeframes, you can better analyze how much profit your company gained.
Cons of accrual-basis accounting
Greater difficulty: Accrual accounting is more complicated to navigate, which can lead to unintentional errors or, worse, deceptive practices such as hiding mistakes in financial reports.
Staffing requirements: With a more complicated method as well as required monthly reports, businesses often require dedicated staff (or even an entire department) to successfully manage accrual accounting.
- 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.
Is cash- or accrual-basis accounting best for my business?
To understand which form of business accounting is the best fit for your company, you should first figure out your company's current standing and goals. Start by asking yourself these questions.
Is my company required to use the accrual method for tax purposes?
These are some of the cases where the accrual method is actually required for tax compliance:
- Companies with inventory or goods
- C corporations
- Companies that have excess of $5 million in gross sales revenue (this is not so cut-and-dry, so you will want to talk with a tax professional to determine if you fall into this category)
Who needs to know my company's financial information?
If a small handful of internal managers look over your financial information for relatively straightforward decision-making, then the cash method could be appropriate; however, management will be limited to the financial information available when making decisions. [Looking for accounting software for your business? Check out our best picks and reviews.]
In cases where there are external stakeholders that need to be privy to your company's financial information (such as investors, banks and advisors), you will want to utilize the accrual accounting method. This method will provide insight into the shape your company is in financially. Furthermore, using the accrual method shows external stakeholders that the business has the financial savvy to grow.
Where do I want my company to be in five years?
If you are happy with your current number of transactions and do not foresee much growth for your business, then the cash-basis method could be the right fit. However, if you have goals to advance your company beyond its current revenues – particularly if you think that revenue will rise above $5 million – it is best to implement the accrual method as soon as possible. The accrual method will provide a better picture of your company's financial results, which allows 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 a cash basis to an accrual basis for your accounting method can be a daunting task, especially if your internal accounting resources are limited. In these instances, it may be worth seeking guidance from an outsourced accounting team. They can facilitate the transition and then provide the ongoing accounting support and financial analysis necessary to effectively run your company, analyze your operations, and guide your business decisions.
Jason Kruger contributed to the writing in this article.