How to Pick the Right Accounting Method for Your Business
The two most commonly used accounting methods in business are cash and accrual basis methods. However, you can’t simply select one, assuming it will be the perfect fit for your business. Natalie Simmons, partner at 415 Group, explains the pros and cons of each.
The accounting method you select will impact your business throughout the year. As an owner, you will make decisions, such as making major purchases, based on the information provided by the statements.
There are pros and cons to both the cash basis and accrual basis methods. Let’s start with the cash basis method.
The cash basis method is typically the easiest to use for small businesses. You only track the money coming in and the money going out. So, you will easily know how much cash you have on hand. By controlling the timing of some transactions, you can impact your tax liability.
However, by using the cash basis method, you have a limited picture of your business. It does not show liabilities owed or what customers may owe you. You are not able to use the cash method if you have inventory (permissible in certain situations) or if your gross receipts are greater than $25 million.
So, what about the accrual basis method?
This accounting method is more complicated to learn. It involves more entries to make, since you record a transaction (such as an invoice to pay) when you receive it and then also later when you record the payment.
On the plus side, the accrual method does give you a better overall look at your business. You’ll be able to know what income should be coming down the line and what expenses still need to be paid.
After selecting an accounting method, you may later realize you are using one that isn’t quite right for your company. You will have the opportunity to change it, with approval from the IRS. This can only be done once every five years.
You may also land in a situation in which changes are made to regulations (for example, the Tax Cuts and Jobs Act of 2018) and it makes sense for you to select a different method. If this happens, you will want to consult with your accountant to decide what the best plan is.
There is the potential that your business would benefit from a hybrid accounting method—modified cash basis. In this case, sales and expenses for long-term assets use accrual basis, while other short-term assets use cash basis.
The modified cash basis method provides a clearer financial picture without requiring the accrual method learning curve. However, this method does not comply with generally accepted accounting principles (GAAP). So, it should not be used when issuing GAAP financial statements.
Business owners should work with trusted advisors to explore their options and determine which method best fits their business. At 415 Group, we do just that. If you’re just starting out or considering making a switch, reach out to us today to find out how we can help you through the process of selecting an accounting method.