Accounting Basics for Small Business: Cash vs. Accrual Accounting

If you’re just starting your business, you’ve got a lot of decisions to make. Not only do you need to figure out how you’re going to make your product or provide your service, but you also need to figure out where the money’s going to come from, what business form to take, and even carpet color for the office in some cases.

One of the important choices you need to make is whether you’re going to use cash basis accounting or accrual basis accounting. Both methods track your business income and expenses, but they work quite differently.

Cash Basis Accounting

The vast majority of small businesses operate on a cash basis. The way this method of accounting works, income is counted when an actual payment of cash (or another payment format) is received. Expenses, too, aren’t counted until they are actually paid.

This is the most straightforward method of accounting for a small business. If you do work for a client in December, but don’t get paid for it until January, the payment is recorded in January. Likewise, if you purchase a new computer for your business on credit in June, but don’t pay for it until July, you record the expense as occurring in July.

The cash basis accounting method gives you the most accurate picture of how much cash your business actually has on hand. Unfortunately, it can show a distorted picture of your business’ overall profitability. One month might be tremendously profitable, and sales could have been slow, which makes things look better than they are when using the cash basis accounting method.

Accrual Basis Accounting

The accrual basis accounting method, in contrast, enters transactions when the order or delivery is made. It doesn’t matter when you actually receive or pay for the item or service; it matters when the transaction is first initiated.

So, for example, if a client orders several hundred of your widgets in August, the income is counted in August – even if they don’t pay the bill until October. If you order new inventory from your supplier in May, it’s counted for May – even if you don’t pay for it until July.

The transaction date isn’t always intuitive when using the accrual basis accounting method. The date you want to keep in mind is the completion date. If you have a contract and deliver all of the goods or provide all of the services in that contract, the date that it’s completed is the date the income is recorded. Likewise, if you purchase goods or services, you don’t record the expense until you have those goods or services.

The accrual basis accounting method shows in a more accurate fashion exactly how your business flows. That said, it will not always let you know what cash reserves are available. That can be a problem, as many small businesses don’t have a lot of wiggle room when it comes to cash flow. If the accrual basis accounting ledger shows thousands of dollars in unpaid sales, your bank account could still be empty.

Picking the Right Accounting Method for your Business

Some businesses are allowed to choose either the accrual basis accounting method or the cash basis accounting method. If your business has less than $5 million in sales each year, you can choose between cash and accrual basis accounting methods.

However, there are some cases in which you must use the accrual basis accounting method. If your business has more than $5 million in sales per year or if you stock inventory and sell to the public with gross receipts over $1 million each year, you’re required to use the accrual basis accounting method.

Why it Matters

The accounting method you use impacts your business most significantly in the way your tax year ends. If you incur an expense during one tax year but don’t pay it until the next, under the cash basis accounting method you can’t deduct that expense until you actually pay it. If you use the accrual basis accounting method, you can claim it in the tax year it was incurred rather than when it is paid.

Talk to your accountant and your tax professional today about which method of accounting makes sense for your small business. In some cases, you don’t have a choice, of course; but when you do have a choice, consider both options and see which best fits your needs.

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