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The two primary accounting methods for small business owners are cash basis and accrual basis. In cash basis accounting, income is recorded when received and expenses are recorded when paid. In accrual basis accounting, income is recorded when earned and expenses are recorded when incurred. Any business is free to use accrual accounting. Businesses with $25 million or less of gross revenue in the last three tax years are free to use cash basis accounting.
Most small 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.
As the person who runs your company, you should know both the difference between the two main accounting methods for small business, who is eligible to use each, 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. Read on to understand the two main accounting methods, along with some lesser known accounting methods.
Your accounting method matters both in terms of bookkeeping and tax filing. 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 about 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 up front.
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 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 and maintain their books using the cash basis accounting method.
In cash basis accounting:
Accrual basis accounting is typically used by larger businesses, though small businesses can use it, too. In accrual basis accounting:
Most small business owners choose cash basis accounting due to the simplicity. However, there are a few situations which might impact your choice of accounting method:
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.
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.
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.
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:
In some cases, you can use a variety of these methods to get different perspectives onto your business. For example, you might use the cost basis method for high-value equipment and cash basis accounting for your financial statements.
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 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.