Cash vs Accrual Accounting: Small Business Edition
Should small businesses use cash or accrual accounting?
Well, that depends, as every small business has its specific needs and goals. You’ll ultimately need to choose an accounting method, cash vs accrual.
Regardless of whether you choose accrual vs cash basis accounting, you’ll be recording sales and expenditures. The difference is in how each model processes this information. Your financial reporting method will determine at what point in the transaction process your account for a service being completed.
Deciding between cash or accrual accounting systems will come down to how you want your company to operate. To help, we’ve made this cash vs accrual accounting small business guide, to help you make an informed choice.
Examples of Cash Basis Method
The main difference between cash basis vs accrual basis is that the former starts financial records when transactions are enacted. This means that revenue is only tallied after cash has been accepted, and expenditures are only calculated when paid.
So, should you use cash or accrual accounting for small business records? Many companies decide on the cash basis method, which is straightforward and easy to monitor. As this method doesn’t account for receivables or payables, recording transactions is relegated only to money that’s actually been received or spent.
This simplifies your ability to see the company’s standing as your bank account reflects all available funds. The cash basis method also makes accounting for tax easier. This is because revenue isn’t subject to taxation until the transactions have been recorded.
Pros & Cons of Cash Basis Method
The main benefit of cash vs accrual for small business accounting is that it’s incredibly simple. The methodology you apply to your personal banking is analogous to the one you would apply to your small business. Unlike an accrual basis, you don’t need to record receivables or payables.
Many businesses that keep a small inventory on-hand or perform mostly cash transactions will opt for cash basis accounting. This way, they can monitor their accounts in real-time without complicated formulas.
One of the major incentives for choosing cash vs accrual is that you only pay taxes when you receive income, rather than when you expect to receive income. For example, if you perform a service in this tax year and deliver the invoice, you won’t be taxed until the client has settled their debts with you, even if it’s in the following year.
The downside of using the cash basis system is that you don’t always have a clear view of your financial standing. Because a transaction isn’t recorded until it’s been completed, you could be forgetting some of your liabilities. Without the inclusion of receivables and payables, your business could appear more cash-rich than it really is.
Examples of Accrual Basis Method
When comparing accrual vs cash basis, the accrual method is a little more complex, but will give you a better overview of your small business’s financial health.
With the accrual method, your recordkeeping begins when income and expenditures are earned or debted. Unlike the cash basis method, you don’t wait for money to leave or enter the bank before accounting for the cash flow.
For instance, if you complete a service this year, you would account for the income with the invoice’s delivery, regardless of when the client’s debt is settled. Most businesses use this method, which is often required for businesses with annual sales exceeding $25 million.
Pros & Cons of Accrual Basis Method
When choosing between cash vs accrual accounting, small business owners will frequently select the accrual method, as it paints a clearer financial picture to help plan for future endeavors.
This long-term view is acquired through accounting for money earned and payable within specific timeframes. This accounting will allow you to decipher the metrics of your company’s performance more accurately over the year, and in relevant subdivisions of quarters. Plus, it falls under the standards of the Generally Accepted Accounting Principles (GAAP).
This method has its faults, too. One of the more significant drawbacks is that it’s not as simple as the cash basis method. Using the accrual system, you might be left with an unclear view of your true cash flow. While you might believe that your business is prospering due to the number of services rendered, your bank account may be falling behind as you wait for payments. This lack of short-term awareness means that you need to invest more resources into monitoring your cash flow, increasing your accounting overhead.
Choosing the Best Option for Your Business
When choosing cash vs accrual accounting, small business owners need to focus on their company’s needs and what they predict their company will do in the future.
As the accrual method isn’t necessary until your business has grossed more than $25 million in sales, you’re at liberty to choose the accounting style you prefer. However, if you don’t plan to surpass that $25 million mark and typically maintain a small inventory, cash basis can work just as easily as the accrual method. Be aware, the IRS won’t allow you to change your accounting method in the middle of the year.
If you’re starting up a company and you’re not sure which accounting method is suitable for your small business, contact L3 Funding today. We can get your business up and running with a wide range of merchant funding services. To learn more, please contact us or fill out an application form today!