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Most small business owners don’t give the accounting method they use much thought. Your CPA might have told you your tax return is filed on cash basis, but you might not know what that means. Or, maybe you noticed your client billings don’t show up on your financial statements, but you don’t understand why. There’s a reason your paperwork looks the way it does—and it’s because, at some point, whoever runs your books picked been the two main accounting methods for small business.
As the person who runs your company, you should know both the difference between the two main accounting methods for small business and when each method is the best choice. At minimum, it’ll clear up the confusion as to why your statements appear to catalog certain things and not others.
Plus, you’ll be able to better understand your business’s finances—which, in turn, will help you make better business decisions.
If you use business accounting software, chances are you’re already familiar with the two most commonly used accounting methods for small business, at least by name. When you set up your bookkeeping software, you have the option to choose either cash basis or accrual basis.
Both accounting methods have their advantages (and disadvantages). Let’s take a closer look at each accounting method.
Cash basis is the most common accounting method used by small businesses. Most small businesses—with a few exceptions, which we’ll discuss later—file their tax returns using the cash basis accounting method.
In cash basis accounting:
1. The recordkeeping is easy. If you’re recording income when you receive it, and expenses when you pay them, you can essentially use your check register to do your bookkeeping.
In cash basis accounting, you don’t have to worry about entering invoices and bills into your accounting software. That doesn’t mean you won’t use these features—they’re very helpful to make sure no income or expenses fall through the cracks—but it’s not necessary to be up to date on these entries in order to produce cash basis financial statements.
2. Cash basis accounting tracks cash flow (sort of). You might be thinking it makes perfect sense to record income when you are paid and expenses when you pay them, because this shows you your business’s cash flow. This is true, to an extent.
Many small business owners choose cash basis accounting because they think all their cash payments will appear on their profit and loss or income statement, and they can then see where all their cash is going just by looking at this one report. It’s important to remember not all cash movement appears on your P&L, though.
If you have business loan payments, or are taking your compensation from the business in the form of draws or distributions, this cash flow activity will not appear on your P&L. Using cash basis accounting for cash flow tracking purposes only shows part of the picture.
1. Cash basis accounting can give you a distorted picture of how your business is performing. Let’s look back at the work you invoiced your customer for in July, but which the customer paid for in August. In fact, let’s say you did a whole lot of work in the second half of July, but your customers didn’t pay you until August for that work due to the generous payment terms on your invoices.
When you look at your financial statements in a few months, you might draw the conclusion that August was a very busy month for you and July was pretty slow. After all, there was a sizable income entry for August in your financial statements. And, you might make business decisions based on this information, like deciding to cut labor in the last half of July, or even taking a long vacation. This could be a costly mistake, especially if your business typically does a lot of billable work in July (or any other given month).
2. Cash basis accounting makes it harder to track profitability by month. Remember the rent payment you forgot to make in June? If you are using cash basis accounting, you won’t have a rent payment on your financial statements for June, which in turn will skew your net profit for the month. As was the case for the work which you performed in July but weren’t paid for until August, cash basis accounting can in this case lead you to make an unwise business decision if you are expecting to have excess profit in the month of June.
Accrual basis accounting is typically used by larger businesses, though small businesses can use it, too. In accrual basis accounting:
1. Better ability to track your business’s performance. Using accrual basis accounting, you can easily see that July is actually a very profitable month for you, In fact, rather than cutting labor during the last half of July, you might decide it would be wise to increase your workforce in order to accommodate more customers during this peak month.
2. Better ability to track profitability by month. Using the accrual basis accounting method, you would be able to easily see your actual net profit for each month. This can help you avoid the costly—and embarrassing—mistake of overcommitting on expenses you might not actually be able to afford.
1. It can be harder to detect cash flow problems. When you use accrual basis accounting, a third financial statement becomes critical to your business decisions. The Statement of Cash Flows reconciles your accrual basis financial statements (especially your P&L) to your cash on hand.
Let’s take one last look at that work you did in July and were paid for in August. Your net profit for the month of July on your accrual basis P&L is going to look really good. Your bank account, on the other hand, might be hovering close to $0, because you haven’t actually received that money yet.
Being cash flow positive is crucial for survival. Accrual basis financial statements can lull you into a false sense of security if you don’t have a good cash management system in place.
2. It’s more time intensive to administer. When you run your financial statements on an accrual basis, you must make sure all bills for expenses due and invoices for work done have been entered into your accounting system before producing the reports. This can make the end of the month stressful for you, especially if you don’t keep up with your bookkeeping throughout the month.
Given the descriptions above, you might be tempted to choose cash basis as your accounting method and not look back.
Not so fast.
Although most small businesses can choose the cash basis accounting method, there are some situations when you must use accrual basis accounting:
The IRS is pretty lenient about which accounting method you choose (though once you choose one method, you have to stick with it unless you get permission from the IRS to make a change). But once your business averages $5 million in gross receipts, you must file accrual basis tax returns.
Even if your business falls below the $5 million threshold for accrual basis tax return filings, if you sell inventory you must account for it on an accrual basis. This is often referred to as a hybrid basis. Talk to your accountant if this situation applies to your business.
Some states require sales tax returns to be filed on an accrual basis. If you live in one of these states, it’s critical for you to have solid accounts receivable and collection procedures in place. Otherwise, you might find yourself having to pay sales tax on an invoice you have not yet collected payment for, which could have devastating effects on your cash flow. (Again, an accountant will help you out here to figure out if this applies to you.)
What if you file your tax return on the cash basis accounting method, but for management purposes it makes more sense to review your financial statements on an accrual basis?
Good news! You can have things both ways! It’s perfectly acceptable for you to manage your business using accrual basis financial statements. In fact, we recommend using accrual basis financial statements for management purposes if your business invoices customers for payment at a later date or if your business has extended payment terms with any vendors.
Now that you know the difference between the two most commonly used accounting methods for small business and the benefits and pitfalls of each, you can confidently decide which method works best for your business.