Accounting isn’t just the practice of tracking all your company’s spending and earning. It’s also a crucial part of long-term business planning and tax compliance. That’s why new business owners need to carefully choose which of the two types of accounting methods works best for them: cash-based or accrual.
The good news is, both new and longtime business owners can switch their accounting method if they feel dissatisfied. However, this change is easier said than done. To avoid the challenges associated with switching your accounting method, make the right choice from the start using the below information.
What is cash-based accounting?
Cash-based accounting is an accounting system in which your company records expenses immediately upon payment and income immediately upon receiving money. In other words, cash-based accounting tracks not when a transaction is made, but when the money you lose or earn in the transaction is actually taken from or deposited into your business bank account.
The benefits of cash-based accounting
Among the benefits of cash-based accounting are:
- Simplicity. With the cash-based method, you record income when it hits your bank account and expenses when the cash leaves your bank account. There’s nothing complicated about it – you can even do it without an accountant.
- Cash flow. You’ll get an immediate feel for your cash flow when you use the cash-based accounting method. That’s because the cash-based accounting method shows how much cash your company actually has on hand. Incomplete transactions aren’t part of your ledger.
- Single-entry. Cash-based accounting concerns a single entity: cash. You don’t need a complicated accounting software system (or an accountant on your team) for this type of accounting method.
The disadvantages of cash-based accounting
Based on the above advantages of cash-based accounting, you probably realize that it’s a pretty simple system. You also likely know that business is complex. That’s why cash-based accounting has some flaws:
- Lacks performance information. Since you’re just seeing cash flow, you have minimal information about where your cash is coming from or how your business is earning its money.
- Lacks liability information. Without liability information, you can’t know how much money to keep on hand to cover these expenses if and when they arise. Cash-based accounting could thus lead you to spend money you don’t have. You also can’t tell why you don’t yet have that money.
- Limited use. Not every business can use cash-based accounting, including:
- Transition challenges. When you use cash-based accounting, you make a strong commitment. That’s because, to switch your method of accounting, you need to add accounts receivable, accrued expenses, and prepaid expenses to your ledger. You’ll also need to subtract cash payments, receipts, and prepayments.
What is accrual accounting?
Accrual accounting is an accounting method through which you record your earnings or losses upon making a transaction instead of when the cash actually enters or leaves your bank account. As such, accrual accounting allows you to combine your current earnings and losses with predicted ones to get a better sense of your company’s finances.
The benefits of accrual accounting
Accrual accounting for small businesses has the following advantages:
- Strong performance tracking. Since you’ll see all your current and predicted earnings and losses with accrual accounting, you’ll get a strong sense of which products and services are bringing in the most revenue. You’ll also get a clear picture of your costs and maybe even how to cut them.
- Better long-term view of cash flow. Although bookkeeping tends to involve tracking finances for a given month, many business transactions take place over several months. Accrual accounting keeps far better track of these transactions.
- Smarter spending. Since accrual accounting records transactions when they happen rather than when cash moves in and out of your bank account, you won’t accidentally spend money you don’t have.
- Better planning. Using the accrual method allows you to track all your revenue and expenses during a given time period, so it’s better for planning. You’ll know how much money you can budget for all your expenses ranging from office rent to employee salaries.
- Attracts investors. If you plan to grow your business through investor money, you’ll want to opt for the accrual method. Investors take a close look at your finances before investing, and they’re less likely to give money to companies that use cash-based accounting.
- It may be required. Businesses with more than $5 million in revenue must use the accrual method.
- Experts prefer it. The Financial Accounting Standards Board’s Generally Accepted Accounting Principles (GAAP) state that accrual accounting is preferable. According to GAAP, accrual accounting leads to more accurate financial statements since it indicates when transactions occur instead of when cash moves in and out of bank accounts.
The disadvantages of accrual accounting
While GAAP and investors prefer accrual accounting, the complexity that draws them in can pose certain challenges:
- Can be challenging for smaller businesses. Given the breadth of income and expenses that accrual accounting covers, smaller businesses with fewer accounting employees may lack the capacity to properly manage accrual accounting. Larger companies, on the other hand, can easily hire entire teams to oversee accrual accounting.
- Demands frequent reporting. If your company’s capacity to generate and share reports is limited, you might struggle with the accrual accounting method. That’s because you’ll need to create accrual accounting reports at least monthly. You might need to create accounts receivable and payable accounts even more frequently.
- Leads to premature tax payments. If you use accrual accounting, you’ll file income statements to the IRS displaying some transactions for which you haven’t yet been paid. That means paying taxes on money you don’t actually have.
The two types of accounting methods: A comparison chart
This comparison chart can help you directly compare and contrast the difference between the two types of accounting methods.
|Cash-based accounting||Accrual accounting|
|Understanding of cash flow||Short-term||Long-term|
|Can C corporations use it?||No||Yes|
|Can companies that sell items on credit use it?||No||Yes|
|Can companies with inventory as part of income use it?||No||Yes|
|Can companies that provide customers with credit use it?||No||Yes|
|Limit on allowable gross receipts||Yes||No|
|Ease of transition between accounting methods||Challenging||Easy|
|Spending decisions||Possibly ill-informed||Fully informed|
|Planning decisions||Possibly ill-informed||Fully informed|
|Investor attraction||Unlikely||More likely|
|Expert opinion||No opinion||Recommended|
|Small business use||Easy||Potentially challenging|
|Taxes on unpaid client invoices||No||Possibly|
How do I know which accounting method is better for me?
For starters, there are certain companies that can’t use the cash-based accounting method. You’ll know to choose accrual accounting if that’s the case. If not, then you have a choice to make.
Many accountants suggest cash-based accounting for small businesses that lack inventory and/or annual gross receipts below $25 million. For companies with inventory or annual gross receipts above $25 million, accrual accounting may be better. If you’re unhappy with your choice, you can switch at any time.
How can I switch between cash and accrual accounting?
To switch between cash and accrual accounting, you’ll need to file IRS Form 3115. Once the IRS approves your form, you can immediately begin the transition – and get an ideal picture of your financing needs.
To discover how your business financials stack up for funding, use our easy-to-use online tool. SmartBiz Advisor™ helps you track the financial health of your business and learn how banks typically evaluate your business.* SmartBiz Advisor also suggests ways to help you improve your credit and strengthen the financial health of your business as needed. Read feedback from real SmartBiz Advisor users and sign up here.
*The information provided through SmartBiz Advisor, including the Loan Ready Score, is for educational purposes only. SmartBiz Advisor is not a financial or legal advisor as defined under federal or state law. Use of this information is not a replacement for personal, professional advice or assistance regarding your finances or credit history.