In the realm of accounting, there are two principle methods of managing your financials: cash basis accounting and accrual basis accounting. Small businesses tend to use the cash basis accounting method, which records transactions when the cash actually changes hands rather than upon completion of a service or delivery of a product (accrual basis). In other words, income (or revenue) is recognized when you receive payment, and expenses are recognized when they are actually paid.
For example, if you’re the owner of a landscaping company and your crew finishes up a big job in May, but you don’t get paid until July, you would record the income in your July books. The only exception to this rule is when expenses are paid with a credit card. In this case, the expense is considered paid on the date it’s charged to the card.
For tax purposes, the accounting method that you use is crucial because it determines when you recognize income and deduct expenses. In some cases, as discussed below, the IRS will prohibit a business from using the cash method. However, if your business is not mandated to use the accrual method, you can decide which method of accounting to use. All accounting methods have advantages and disadvantages, and there isn’t one method that will work well for every business. As a small business owner, it’s important to understand the advantages and disadvantages of cash basis accounting to decide if it’s right for your small business.
- Easy to Understand: Cash basis accounting tends to be simpler to understand than other accounting methods. If you choose to implement the cash method for your small business, it may not be necessary to seek the help of a professional accountant.
- Shows Cash Flow: The cash method most resembles a cash flow statement. It provides an accurate picture of how much cash your business actually has on-hand.
- Single-Entry System: The cash method can be done with a simple single-entry system, so a complex accounting program is not always necessary. This is, however, also one of its drawbacks, which is outlined below.
- Single-Entry System: While the simplicity of the single-entry system needed for the cash method is an advantage, it is also a disadvantage. The accrual method necessitates the use of a double-entry system, which is based on accounting equations. This system provides far greater control of transaction posting, and reduces the chance of errors.
- Short-Term Indicator: While it does indicate the cash flow of a business, it may offer a misleading picture of longer-term profitability. The cash method doesn’t show income that has been invoiced but not received. Furthermore, it doesn’t take future expenses into account. It can also be misleading. For example, your books might show one month as being extremely profitable. However, deeper insight may reveal that sales were actually slow, but a number of customers paid their outstanding bills.
- Restrictions: According to the IRS, you cannot use the cash method if your business maintains inventory, is a corporation, or has gross receipts in excess of five million dollars per year. These are the general rules, but there are exceptions — so if you feel that your business falls into one of these categories, you should consult a professional.
While cash basis accounting may be more simplistic, it may also limit you from making more predictive decisions for your business. Measure out the pros and cons for this method with your particular business in mind. Remember that online accounting software can be helpful in setting up the accounting method of your choice.