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.
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.
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:
These are some of the cons of cash-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.
Accrual-basis accounting also has potential advantages and disadvantages.
These are some of the pros of accrual-basis accounting:
These are some of the cons of accrual-basis accounting:
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:
These are some types of companies that are required to use the accrual method for tax compliance:
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.
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 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.