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.
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.
Among the benefits of cash-based accounting are:
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:
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.
Accrual accounting for small businesses has the following advantages:
While GAAP and investors prefer accrual accounting, the complexity that draws them in can pose certain challenges:
This comparison chart can help you directly compare and contrast the difference between the two types of accounting methods.
Cash-based accounting | Accrual accounting | |
---|---|---|
Complexity | Low | High |
Understanding of cash flow | Short-term | Long-term |
Entries | Singular | Many |
Performance information | Limited | Thorough |
Liability information | Limited | Thorough |
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 |
Reporting requirements | Minimal | Extensive |
Taxes on unpaid client invoices | No | Possibly |
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.
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.