Cash vs. Accrual: Which Accounting Method Works Better for Your Business?
Every business must have an accounting method, which governs how and when to report revenue and expenses. The accounting method you choose can help guide financial decisions for business activities, impact your taxes, and even affect the ability to obtain a commercial loan.
What are the most common accounting methods used by small businesses?
There are two primary accounting methods used by businesses in recording and reporting financial transactions: cash basis accounting and accrual basis accounting. The difference between the two determines when income and expenses are recorded, which can have an effect on profit and loss, as well as income taxes. The cash method is generally easier to use but the accrual method can provide a more accurate picture of a business's financial performance.
Cash basis accounting
The cash method is easy to understand and follow. Most small businesses and individuals operate on a cash basis and prepare their income taxes using this method.
Under the cash method, income is recorded when payment is actually or constructively received. Constructive receipt means an amount is credited to your account or made available to you without restriction. For example, you receive a check in December for services you performed. You don't cash the check until January, but you must report the income in December; you had control over it then. If you're paid in property or services rather than in cash (including a check credit card or electronic transfer), the fair market value of the property or services is income when received.
Under the cash method, expenses are recorded when paid to vendors for purchases of products or services. For example, your rent is due on the first of the month. If you pay early, say the 28th of the previous month, that's when you record the payment. If you pay late, such as the 5th of the month that the rent is due, that's the day the expense is recorded.
Under the accrual method of accounting, revenues are recorded when earned and expenses are recorded when incurred, rather than recording revenues and expenses when payment changes hands. More specifically, income is recorded when all the events that fix your right to receive it have occurred and you can determine with reasonable accuracy what that income is ("economic performance test"). For example, you fulfill an order and ship the goods. You record the income upon shipping because all events have occurred to create your right to payment and you know what that payment should be. You don't wait until payment is received.
The same rules govern the treatment of expenses. For example, your rent is due on the first of the month and this is the date for recording the expense, per the accrual method. It doesn't change whether you pay early or late.
Hybrid method of accounting
There is a third accounting method allowed by the IRS under certain circumstances — the hybrid method of accounting. This method, however, is typically not used because it is less clearly defined and more difficult to manage. The IRS allows for any combination of cash and accrual methods if:
- The hybrid clearly reflects your revenue and expenses, and
- You apply the method consistently.
As you can see, this definition is quite broad and allows for a great deal of interpretation, which can be problematic in the event of an audit. For most business owners, choosing either the cash or accrual method and applying it consistently is the best option.
How to choose the right accounting method for your business
For tax purposes, the accounting method that you use is crucial because it determines when you recognize income and deduct expenses. In some cases, some businesses can't use the cash method and must use the accrual method. However, recent tax law changes have expanded the opportunity to use the cash method if desired. All accounting methods have advantages and disadvantages, and there isn't one method that will work the most effectively for every business. As a small business owner, it's important to understand the advantages and disadvantages of cash vs accrual accounting to decide what is right for your small business.
Cash vs. accrual accounting
- Cash basis accounting is easier to understand and use. Because the cash method is intuitive — you report income when received and note expenses when paid — it may not be necessary to seek the help of a professional bookkeeper or accountant. You can easily record transactions in your accounting software (discussed below).
- Cash basis method shows cash flow. Because the cash method follows the flow of income in and out of your business, it provides a more accurate picture of how much cash your business actually has on hand. In other words, monitoring cash flow parallels your accounting method.
- Cash method doesn't have the same control as the accrual method. Transactions can be more easily systematized under the accrual method, giving greater ease of posting them and reducing the chance of errors.
- Cash basis accounting can be misleading. The cash method doesn't show the full picture of income. For example, it doesn't reflect income that's been invoiced but not yet received. And it doesn't take future expenses that the business will have to pay into account.
- Cash method is barred to certain big businesses. This method can't be used by a C corporation (or a partnership with a partner that's a C corporation) if average annual gross receipts for the three preceding years exceeds a set dollar amount ($26 million in 2020). This is called the gross receipts test.
- Cash method is barred to larger companies under certain accounting principles. As explained below, big businesses must use the accrual method to conform to accounting principles.
When should you use cash basis accounting?
- You're starting out your business. The cash method is generally easier to use than the accrual method, so when you're starting out, you may want to keep things simple.
- You want better control over taxes. Using this method provides latitude near year-end to defer or accelerate income and/or expenses. For example, if you perform services in December, you can delay billing so that payment is received (and is taxable) in the following year.
When would you use accrual accounting?
- You have an inventory. If you do not qualify under the gross receipts test noted above, you must maintain inventory. Doing so under the accrual method is standard operating procedure.
- You want to stay on top of receivables and payables. In the cash method, you only report results (the receipt of revenue or the payment of an expense). But if you want to keep tabs on what's outstanding so you can follow up as needed, the accrual method gives you a better handle on your accounts receivable (A/Rs) and accounts payable (A/Ps).
- You want a long-term view of your company's financial situation. It's easier to see what's happening within a set period, so you can know when the business is growing or slowing, and take action accordingly.
- You need to conform GAAP. The Generally Accepting Accounting Principles (GAAP) standard for accounting rules requires businesses with revenue over $25 million to use the accrual method so financial reporting conforms to these rules.
Other accounting methods
There are other types of accounting methods that take the place of cash or accrual, and are used in special situations. Examples:
- Installment method. Whether you use the cash or accrual method, you can also use the installment method to report gain from a sale in which payment is received in more than just the year of sale. This allows you to spread the gain and more closely align tax reporting with the receipt of payments. This method doesn't apply to sales of inventory.
- Percentage of completion method for long-term contracts. This is commonly used in the construction business where erecting a building can take considerable time. It applies when contracts extend into the following year and allow for deferral of income and expenses until contracts are completed (with limitations). However, small contractors and home construction contracts of larger contractors are exempt from having to use this accounting method.
How accounting software can help
When determining which accounting method to use, accounting programs can be helpful. You don't have to be an accounting expert to be able to accurately record your income and expenses. Most accounting software allows you to set up your accounting system using either the cash or accrual method, and some even allow you to toggle back and forth between methods for purposes of viewing reports. This can be useful when analyzing how each method affects your profit, loss, and taxes. But keep in mind that if you use one method of accounting and want to make a change, you must file for a change in accounting method with the IRS and make any payments for doing so.