Cash or Accrual? How to Choose the Best Method for Your Business

Tracking your income and expenses can be tedious, but good accounting practices are essential to controlling cash flow, reducing taxes and keeping your business growing. You may already know that there are two primary methods of keeping your books: cash or accrual. To help you choose the best fit for your business, let’s review the pros and cons of each method.

What is Cash Basis Accounting?

With the cash method, you simply record income when money is received and record expenses when money is paid.

Cash accounting does not track accounts receivable or accounts payable. If you sent an invoice to your customer on June 1 and received the customer’s payment on July 10, you would record the income in July. Likewise, if you purchased raw material on credit in August, but did not actually pay the bill until September, you would record the expense in September.

Advantages of Cash Accounting

Simplicity -- Most small business owners start with the cash method because it requires the least bookkeeping entries. Keeping track of what you deposit and pay is no more complicated than handling your personal finances.

Flexibility at Tax Time – When using the cash method, you don’t have to pay taxes on money which has not yet been received. For example, if you invoiced a big job in November and gave the client 60 days to pay, your income taxes on the money received in January will not be due until the following January.

Disadvantages of Cash Accounting

A Rear View of Cash Flow – Because cash basis does not show income which will be coming soon (or bills you will soon have to pay) you are making this month’s decisions based on last month’s results. 

No Visibility of Accounts Receivable or Payable – With no AR or AP, your books are not helping you manage resources toward dates when income will be received (or payments will be due).  A limited view of receivables and payables is not what a banker will want to see when you apply for financing.

Does Not Conform to GAAP – As your business grows, lenders and large accounts will expect to see financial statements which conform to Generally Accepted Accounting Principles. Under GAAP standards, you are no longer able to use cash accounting when your annual sales exceed $25 million.

What is Accrual Basis Accounting?

With the accrual method, income is recorded when a sale is made (not when the money is received), and expenses are recorded when supplies are purchased (not when the bill is paid).  

Accrual bookkeeping tracks accounts receivable and accounts payable. If you sent an invoice on June 1, and then received a check on July 10, you record the income in June. Likewise, If you purchased raw material on credit in August, and paid the bill in September, you record the expense in August.

Advantages of Accrual Accounting

A More Accurate Dashboard – The accrual method shows exactly how much you are earning and spending, providing a better view of your speed and direction as you drive your business forward.

A Clear View of the Road Ahead --  The accrual method takes a little more work, but gives you and your accountant a more accurate picture of your annual, seasonal or monthly business cycles.

Conforms to GAAP – With the accrual method, your accounting system will accommodate the Generally Accepted Accounting Principles expected by large customers and most lenders.

Disadvantages of Accrual Accounting

Requires More Work – The accrual method is more complex, and will require more work by your bookkeeper or accountant. As a result, it will cost more to manage your accounting process.

Requires Separate Cash Flow Tracking – Accrual gives you a better overall view of your finances by accounting for money which will come in (or go out) during a particular period. However, it can appear that you have plenty of revenue when you are actually out of cash. With accrual, careful management of cash flow becomes much more important.

Choose the Best Fit for Your Business

If you’re on track to reach $25 million in annual sales, use accrual accounting. Otherwise, choose the method that best fits your business for this business year. Bear in mind that the IRS will not allow you to change mid-year. Some small businesses adapt a hybrid method, staying with the cash method for income and expenses, but using accrual for high value inventory.

To learn more about using cash and accrual accounting to grow your business, sign up for our free consultation!