Cash vs. accrual accounting: Considerations for tracking your finances
As a business owner, you have many choices about how to operate your business. A key choice you or your tax or accounting professional should decide on prior to starting your business is the accounting method you choose: cash vs. accrual.
Each accounting method has benefits and drawbacks, which we’ll identify in this post. Read on as we outline the basics of accrual vs. cash basis accounting!
Accrual vs. cash basis accounting
First, let’s outline the definition of each type of accounting method, so you can better understand each. While both methods recognize credits and debits, they do it in different ways. Let’s dig in to understand those differences.
What is accrual accounting?
Accrual accounting’s goal is to match revenue and expenses over the course of the same time period. Financial transactions are recorded when you have a legal right to the cash, regardless of when a transaction is made.
While accrual accounting shows a more transparent picture of your company’s finances, its drawback is it can create cash flow issues. So, say your small business banking account is running low on funds and you have a major business expense you need to pay.
Your bookkeeping records indicate you have the resources by using an accrual method of accounting, but you might not actually have the funds in your account to pay the expense because transactions that have been recorded but not paid to you happened within that time frame. Thus, you’d go into a cash deficit.
But it does have its advantages. Accrual basis of accounting offers a more holistic, long-term picture of your business’s financial position than cash accounting.
What is cash basis accounting?
Cash basis accounting recognizes revenues as soon as cash is actually received – and when expenses are actually paid.
Let’s review an example that will better outline to differences between cash vs. accrual accounting. Simply put, if you get a check or payment from a client using the cash basis method, it’s recorded at the time of payment. If you use this method, your business banking balance should reflect the exact resources you have at your disposal.
By contrast, if you’re using accrual accounting, your transaction would be recorded even before a payment was received – so after you invoice a client.
One thing to note about the cash accounting method — You probably don’t even realize you’re already doing it for your personal accounting – it’s the method most people use.
The importance of recorded transactions as a small business owner
Every small business should keep up on its bookkeeping. In fact, if you want to claim a tax deduction, credit, or otherwise, proper bookkeeping informs you or your tax preparer of the important information you need to file on your tax return and business tax forms.
There are great do-it-yourself bookkeeping resources out there such as Wave, or you can outsource bookkeeping services to a pro. Block Advisors bookkeeping services can help you manage your bookkeeping tasks so you can focus on your business.
Should you use cash vs. accrual accounting?
Whether you use a cash basis vs accrual basis will depend on your business’ unique situation and take several facets into consideration, such as overall profits, losses, business entity type, number of shareholders, financial reporting preferences, and more.
If your business is a C-corporation averaging $25 million in gross receipts over the course of three years, the IRS advises you to use the accrual method.
However, if your business is not a corporation and has little cash on hand, you may want to use the cash method of accounting, so your business’ cash flow is more visible. In fact, it’s commonly used by sole proprietors or small businesses without inventory. Some small businesses without inventory can use the cash method, too. The income limits that require the accrual basis are high.