Accounting for Small Businesses: Two Methods
The two primary accounting methods for small business are: cash vs. accrual basis. In cash basis accounting, income is recorded when received and expenses are paid. In accrual basis accounting, income is recorded when earned and expenses are incurred.
Any business is free to use accrual accounting, but only businesses with less than $25 million of gross revenue in the last three tax years can use cash basis accounting when reporting to the IRS.
When it comes to small business accounting, most business owners don’t give the accounting method they use much thought. Your accountant might have told you that 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 businesses: cash vs. accrual basis accounting.
As the person who runs your company, you should know the difference between the two main methods of accounting for small business, who is eligible to use each, and when each method is the best choice. When it comes to small business taxes, using cash basis and accrual basis accounting can have huge consequences. At minimum, learning the difference between cash vs. accrual accounting will 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. Read on to understand the pros and cons of these two main business accounting methods, along with some lesser-known accounting methods.
Why Your Small Business Accounting Method Matters: Cash vs. Accrual
Your small business accounting method matters both in terms of bookkeeping and tax filing. The accounting method affects the way that income and expenses are recorded on your financial statements, and the tax year in which those transactions are reflected.
For tax purposes, the IRS requires businesses to use a standardized and consistent accounting method each year that you file small business taxes. If you choose an accounting method and later want to change it, you must get IRS approval. The IRS allows companies to use cash basis, accrual basis, a specialized method for certain income and expense categories, or a hybrid method. If you don’t choose and use an accounting method consistently, the IRS won’t accept your return. You might end up underpaying taxes and be fined as a result.
Publicly traded companies must use accrual accounting under U.S. generally accepted accounting principles (GAAP). GAAP refers to a set of commonly accepted accounting principles developed by the Financial Accounting Standards Board and Securities and Exchange Commission. Small businesses have more room to decide which accounting method to use.
The bottom line is that legal and tax rules require some form of consistent record keeping, but it goes beyond that. Using a specific accounting method can help you more accurately assess your company’s financial situation and make better decisions. It’s possible, but complicated, to change your accounting method, so it’s a good idea to choose carefully upfront. Let’s go through the differences between cash vs. accrual accounting, and then review some other accounting methods as well.
Cash vs. Accrual: The Most Common Accounting Methods for Small Business
If you use business accounting software, chances are you’re already familiar with the two most commonly used accounting methods for small businesses. When you set up your bookkeeping software, you have the option to choose either cash basis or accrual basis.
Both accounting methods have their pros and cons. Let’s take a closer look at each and what they mean when it comes to accounting for small business.
Accounting Methods: Cash Basis Accounting
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 and maintain their books using the cash basis accounting method.
In cash basis accounting:
- Income is recorded when it’s received. Let’s say you did work for a customer on July 25, and you created an invoice with a due date of August 10. You’ll record the income for this work when the customer pays you in August instead of in July, when you actually did the work. In cash basis accounting, income is recorded when you receive the payment, not when you bill your customer.
- Expenses are recorded when they’re paid. As with income, in cash basis accounting you record an expense when it is paid, not when it’s billed. Let’s say you forgot to pay your rent in June. When you receive your rent statement from the property management company at the beginning of July, you notice the amount due was double your normal rent expense. After verifying you did, in fact, forget to pay your rent in June, you write a check for both month of rent by the July 10 due date. In cash basis accounting, you record the full amount of the expense in July, meaning no rent payment will appear on your financial statements for June.
Pros of Cash Basis Accounting
- Record-keeping is easy. If you’re recording income when you receive it, and expenses when you pay them, you can do most of the legwork on your own without hiring a professional business accountant.
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. The accounting software will automatically categorize income and expenses as they are received or paid, with no manual adjustment to date required on your end.
- Cash basis accounting tracks cash flow. The cash basis of accounting mimics what will appear on your cash flow statement. It gives a good indicator of a business’s cash position and how it changes over time. Cash basis accounting registers bank transfers, check transactions, and credit card payments.
Cons of Cash Basis Accounting
- 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).
- 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.
- Need to track accounts receivable and accounts payable separately. Cash basis accounting registers income when received and expenses when paid. This means that you can’t use cash basis accounting to keep track of invoices that you send to your customers or that vendors send to you. You’ll need to have a separate system for tracking those, so that they accurately appear on your balance sheet.
Accrual Basis Accounting Method
Accrual basis accounting is typically used by larger businesses, though small businesses can use it, too. In accrual basis accounting:
- Income is recorded when it’s earned. Going back to our earlier example, in accrual basis accounting, the income for the work you performed would show up on July’s financial statements, not on August’s.
- Expenses are recorded when they’re incurred. Even if you didn’t make your rent payment for June until July, in accrual basis accounting your financial statements would still show a rent expense for June.
Pros of Accrual Basis Accounting
- Better ability to track your business’s performance. Using accrual basis accounting, you can easily see which are your most and least profitable months. 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. In general, accrual basis accounting allows for better forecasting and budgeting.
- 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.
- It’s what lenders and investors prefer. Lenders and investors have a clearer view into your company’s profitability if you use accrual basis accounting. When fundraising or applying for a business loan, be prepared to share financial information using the accrual method.
Cons of Accrual Basis Accounting
- 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. 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 profit and loss statement 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. So, if you use the accrual method of accounting, you’ll want to view your profit and loss hand-in-hand with your cash flow statement.
- 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. However, it might be fine if you have a professional accountant to help out.
- It can lead to paying higher taxes. Remember, with accrual-based accounting, you’re recording your income on the day it’s earned. This means you might end up paying taxes on money that you don’t actually have on hand yet.
Accounting for Small Business: Which Method Should You Choose?
When to Use Cash Basis Accounting
Most small business owners choose cash basis accounting due to the simplicity. While accrual basis accounting can give you a more realistic view of your business’s profitability, cash basis accounting may be a useful accounting method in the following situations:
1. You’re a sole proprietor, or just starting your business.
Since cash basis accounting doesn’t have the steep learning curve accrual accounting has, this is an ideal accounting method for time- and cash-strapped entrepreneurs juggling many responsibilities at once. If you feel you can’t afford or don’t need an accountant for your small business, then cash basis accounting simplifies matters for you.
2. You’re a cash-strapped business preparing for tax season.
If you’re a new business with not much income coming in and you’re worried about paying business taxes, cash basis accounting may be helpful because it represents how much cash you actually have on hand. If you sold a service or product before the filing deadline, but a client was slow to come up with payment, you’d be able to report the expense for the current year’s taxes, and save reporting revenue until the next year using this accounting method.
When to Use Accrual Accounting
Though cash basis accounting is fairly popular, there are a few situations which might require you to use the accrual basis accounting method:
1. Your small business has average gross revenue of more than $25 million over a three year period.
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 more than $25 million in gross receipts, you must file accrual basis tax returns. Less than that, and you’re good to choose either accounting method. Many companies choose cash basis for its simplicity.
The Tax Cuts and Jobs Act (TCJA) increased the cash basis threshold from $5 million to $25 million and allows qualifying small business taxpayers to file an automatic change request with the IRS if they previously requested a change to cash basis.
2. You have inventory.
Under previous law, businesses that sold inventory were required to use accrual basis accounting. Thanks to the TCJA, if your business has $25 million or less of revenue (over the last three tax years), you can either treat the inventory as non-incidental materials, or use the accounting method that’s reflected in your financial statements or accounting records.
3. You must file sales tax (in some states).
Some states, such as New York, 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. An accountant will help you out here to figure out if this applies to you, or you can contact your state’s tax agency.
Accounting Methods for Small Businesses: More Options
Cash basis and accrual basis accounting are the two most popular accounting methods for small business, and in general, you have to use one of these for tax filing purposes. Although it creates more work for you in the long run, it is possible to use different accounting methods for your books and for tax filing.
Here’s a summary of accounting methods for small business owners:
- Cash basis – Records income when received and expenses when paid.
- Accrual basis – Records income when earned and expenses when incurred.
- Percentage of completion – Revenues and expenses of projects are calculated as part of the overall work during an accounting time period.
- Completed contract – Defers reporting of expenses and income until a project is fully completed.
- High-low – Calculates the change in total operating cost associated with changes in levels of a business activity.
- Cost basis – Utilizes the original value of an asset, adjusted for stock, dividends and capital distributions. This method can be used for calculating an item’s capital gain for tax purposes.
In some cases, you can use a variety of these accounting methods to get different perspectives on your business. For example, you might use the cost basis method for high-value equipment and cash basis accounting for your financial statements.
The Best Accounting Method for Your Small Business Might Be a Hybrid
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. You might also be able to use other accounting methods where appropriate.
Now that you know the differences between cash vs. accrual basis and the benefits and pitfalls of each, you can confidently decide which accounting method works best for your business.