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As a small business owner, you most likely are aware of the two most common methods of accounting: cash and accrual. Whether you decide to outsource your financial reporting to an accountant or CPA, it is still crucial for you to understand both of these methods. If you are a new business owner and just getting started, then you most definitely want to learn the key differences between these two methods of accounting.

What is the Cash Basis?
On the cash basis, you recognize revenues when you deposit money (not when you invoice the client). For example, think of your younger self owning a lemonade stand in your neighborhood. You charged 50 cents for a cup of lemonade. One person pays you the money for the cup while another told you to stop by later in the week to collect the money. When adding up how much you made that outing, you only have 50 cents because that is what you actually have in hand at that moment.

Same goes when you pay vendors. You recognize expenses from vendors when you pay them (not when they bill you). An example of this would be when you receive your internet bill. You won’t actually see that money leave your account until you actually pay the bill.

What is the Accrual Basis?
The accrual basis is the complete opposite of the cash method. Income and expenses are recorded when they are billed and received, regardless of when the actual money is received. For accrual, you recognize revenue when you invoice the customer (not when you receive the money).

This also applies when you recognize expenses from vendors when you are billed (not when you actually pay them).

What’s Best for Your Small Business?
The most common accounting method used by businesses is the accrual basis method. The cash basis method is the easier of the two, since it’s pretty straightforward. The accrual method requires a little bit more bookkeeping due to the time it takes to record and track your income and expenses.

When it comes down to it, there are two sets of financials that are worth noting:
• Financial reports for internal management and external users (such as banks, investors, etc.)
• Tax reporting for the tax returns

You do not have to use the same method for each. In most cases, small businesses with less than $10M in sales will benefit on their taxes from cash basis accounting. By not having to report uncollected sales (accounts receivables) as income, there are usually some tax incentives, especially early on in the business cycle.

Cash basis accounting is easier for many people to wrap their heads around – simply match what is hitting the bank each month. Relying only on balance in the bank to gauge your business performance is not enough to get an accurate picture of how a company is performing. It does not factor in for money owed to the business or owed to others by the business.

In most cases, a company should be evaluating its performance using accrual basis accounting. Matching revenues and expenses to the period when they are earned (not necessarily received or paid) will give you a much clearer picture of how your business is actually performing.

Still not sure which is most suitable for your business? Here’s a quick guide of the advantages and disadvantages of both accounting methods:

Disadvantages
Cash Method
• Can falsely represent how a Company is really performing since it won’t show who owes you money and who you owe money to.
• Can sometimes save money on taxes early in a business with a larger cost in the future by being forced to switch methods.

Accrual Method
• More difficult to keep on the accrual basis. Increasingly so for certain types of businesses, such as construction contracting, field service companies, or manufacturing.
• More sophisticated accountants typically required, internally or externally.
• Accrual accounting can help identify relationships between revenues and expenses to model future financial outcomes, as well as the budget for future revenues/expenses.
• As your business grows, your lenders/investors will definitely want to see accrual-based numbers.
• Eventually, you may have to keep your tax records on the accrual basis as well.
• When and whether you should be doing this is a conversation you should be having early in the business cycle. Once revenues hit $10M, you are forced to go accrual for tax purposes and being caught off guard with this can have some surprising effects.

Advantages
Cash Method
• Easier to keep accurate – less skilled accountants can handle
• Often times results in lesser tax liability, especially earlier in business cycles and for companies who have more money owed to them than they owe vendors (receivables greater than payables)
• Easier to interpret for those without financial backgrounds or comfort

Accrual Method
• More accurate picture of real company performance – more useful for business analysis
• More useful in planning for the future – or for performance-based incentives within the company
• Going to be required in many instances for lenders/investors, bonding, insurance, etc.

Some small businesses can choose a hybrid of accounting, wherein they use accrual accounting for reporting and cash method for their income and expenses. If you’re unsure of which accounting method is the best fit for your business, feel free to reach out to me at josh@insightful.tax.