Cash or accrual: Choosing the right accounting method.
For a small business owner, accounting is as important as it is confusing. How you track your revenue and expenses affects your tax liability and ability to secure a loan. And, it’s useful for tracking how much money is coming in and out, as well as understanding what the future holds for your finances.
There are two main accounting methods, and the good news is understanding the difference isn’t terribly difficult and can help you select the right one for your business. Below we break down what the methods are, the benefits of each, and things to consider.
Method 1: Cash accounting.
The cash accounting method is the simpler of the two and is therefore popular among small businesses. With the cash method, business income is recorded when you receive it, and expenses are counted when you actually pay them. If you complete a project, but won’t be paid for another two weeks, you would wait to record the earnings until they’re given to you. The same is true if you contract a vendor but won’t pay them until they complete their work. You would only record the expense once you pay them.
Note: Although it’s called cash accounting, this method includes all forms of revenue, like checks and credit card payments.
Method 2: Accrual accounting.
With the accrual method, funds are recorded when the transaction is completed, regardless of when payment is exchanged. If you complete a project, but won’t be paid until next month, you would list the anticipated payment amount now. Expenses are also handled this way. The cost is recorded when the order is placed, even if payment won’t be made until further out.
The accrual method is required for businesses whose sales exceed five million dollars a year. Businesses that maintain an inventory of products sold to the public and generate more than $1 million in gross receipts annually must also use the accrual method.
What to consider.
There are advantages and disadvantages to both approaches. The method you use affects not only how your net income is reported throughout the year, but also your understanding of your business’s operations.
- The cash method gives you a clear picture of the funds in your bank account today, but it may be a misleading representation of your business’s longer-term health. It can be harder to see how unpaid sales and expenses factor into your current finances.
Plus, transactions that happened in one year may not appear on your ledger until the next. That can impact your net income come tax time and affect your liability positively or negatively. That can be good if you want a lower tax burden, but keep in mind lenders also look at tax returns when approving financing.
- The accrual method can also paint an incomplete picture. Because transactions are recorded before payment is received, your income ledger may show significant sales that may not be reflected in your bank account because your customers haven't paid you yet. Although you may not know the status of cash for your business, it can provide a more accurate understanding of your business’s monthly operating expenses and revenue.
When it comes to selecting an accounting method, you don’t need to be an accountant, but it helps to have a basic understanding of the two methods. If your business type allows you to choose between the two methods, determine which best aligns with your goals and preferences for managing your business. Because the method you choose will impact your yearly taxes and when you can claim deductions, it’s wise to consult your accountant. You may want to talk to your banker as well – especially if you plan to seek financing.