When it comes to starting, running, and leveling up your small business bookkeeping you may have heard that there are two methods of accounting (Cash and Accrual Basis). Which one should you choose? Should your business change its method of accounting? Let’s explore the details so you can pick the right one for your business.

What is the Cash Basis Method of Accounting?

This is the most common method of accounting used by small businesses. Simply put, the cash basis method of accounting records all of the money that came into your business bank account and went out of your business bank account for a specific period of time (say a month or a year).

Let’s say you got paid by a customer right before the end of a year (December 31st, 2022). That sale will be recorded in the financial records for 2022. The same goes for expenses. If your business pays for a product or a service within a specific time period the expense will be recognized in that time period. Fairly simple right?

Financial Reporting Advantages of the Cash Method of Accounting

If you’re like me, cash is king. The Cash Method of Accounting yields financial reports that show whether your business’ cash situation is increasing or decreasing for that specific period of time. I like that. I think that is a good metric to review.

Tax Advantages of the Cash Basis Method of Accounting

For tax purposes, you generally have a little more control over your tax liability for a specific year when using this method. If you’re having a really good year where profits are high you’re going to owe more in taxes most likely. Yuk. You can mitigate some of this increase in tax liability by increasing your business expenses before the year ends by prepaying for the things your business needs like equipment, insurance, or rent, etc.

You can also bill your customers later to shift some of the revenue into the following year. Having a great December? Tell your customers to pay you in January. Send them invoices due 1/31 of the following year. Receiving the money in the following year shifts the revenue, profits, and tax liability to that year. The cash basis method of accounting is great for having a little more control over.

Do these tax advantages sound appealing to you? Have you been using the accrual method for tax reporting purposes and now want to switch to the cash method? Hold up! It can be done, however your tax professional will need to assist you with requesting the IRS’s approval on a change of method of accounting. Generally once you file your business’s first tax return you choose a reporting method of accounting (Cash vs Accrual) and you’re required to stick to it consistently. You can only change your method of accounting if approval is requested to the IRS and that approval is granted.

What is the Accrual Basis Method of Accounting?

The accrual basis method of accounting is slightly different and more complex than it’s counterpart. This method of accounting lines up revenues and expenses for when they are earned/incurred.

Are you unsure what exactly is meant by terms earned or incurred? Maybe the word “deserved” would be a better term for explaining this concept. I like it.

For example, someone buys products from your business. You ship them the products and send them an invoice. On the accrual basis your bookkeeping records will go ahead and recognize the sale once the products are shipped (and the invoice is created). It doesn’t matter if it takes the customer 3 months to pay you, the sale would be recognized in the month of shipment.

Another example of the expense side of things. Lets say your business orders a piece of equipment. It receives the equipment and an invoice for it. On the accrual basis the bookkeeping records will show the business expense of this purchase in the time period the purchase was made, not the time period the payment of the invoice was completed. Let’s say you wait 6 months or the next year to pay for this item. It won’t change when the expense is placed onto the P&L.

There are other, more complex examples that can be discussed when implementing the accrual method of accounting properly, but those examples are for another article.

Financial Reporting Advantages of the Accrual Method of Accounting

The accrual basis method of accounting aligns revenues and expenses to be reported in the time period that the business earns/incurs/deserves them. The accrual method is said to be a more accurate predictor of current and future business performance. By design when a business reports it’s financials on the accrual basis those financials are supposed to give a clearer picture of how well that business is performing.

I’ve read some articles that say that the accrual method is the “preferred method” of accounting by most businesses. Based on the experience I have had running an accounting firm for the past 12 years focusing on small business owners, I would say, it depends.

The accrual accounting method is generally used for businesses that are larger, usually well past $5,000,000 in revenue. Lenders and investors like it for its supposed clearer reporting qualities, but it all depends on the reader of the financial statements and their goals.

Can we help make your small business bookkeeping better?

We specialize in working with business owners to be their accounting department. They can outsource their small business bookkeeping and let us take care of it all. We provide them with useful, simplified financial reports every month straight to their inbox. We can also manage their complex tax situation as it relates to their ever changing business environment.

If you need help in any of these areas, schedule a call with me today. Click the link below to access my calendar: shoffaccounting.com/schedule

Cash Vs Accrual Basis: What’s Best for your Small Business Bookkeeping?