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.
Timely, accurate financial information is essential to running a successful business. There are a number of accounting methods you can use to record and track your business’s financial performance. Here’s an overview of cash, tax and accrual basis accounting to help you choose a method that’s appropriate for your situation.
Cash basis
Often startups and sole proprietorships default to the cash method of accounting because it’s simple and provides an immediate picture of available funds. This may suffice for small businesses with uncomplicated financial affairs.
Under cash-basis accounting, you record transactions only when money changes hands. For example, if you buy a new computer on credit, you only record it as an expense once you pay cash for it.
While this recordkeeping is easy, it can be challenging to get an accurate picture of your business’s financial situation. This method also isn’t suitable for tax purposes.
Telltale signs that a company is using cash-basis accounting can be found on the balance sheet: The company won’t report any accrual-basis items, such as accounts receivable, prepaid assets, accounts payable or deferred expenses.
Tax basis
Another financial reporting option is to use the same accounting method for book and tax purposes. Under tax-basis accounting, you only record transactions when they relate to tax.
This method can be helpful for companies that want to minimize their tax liability. It can also be beneficial if your business doesn’t have complex financial affairs and you don’t need up-to-date information about your financial situation.
Accrual basis
As your business grows and has more sophisticated financial reporting needs, you may decide to transition to the accrual method of accounting. Businesses that issue financial statements under U.S. Generally Accepted Accounting Principles (GAAP) must use accrual-basis accounting.
GAAP is considered by many to be the “gold standard” in financial reporting. Most lenders and investors prefer statements prepared using this method because it’s the most reliable for long-term financial planning and decision-making purposes.
Under accrual-basis accounting, revenue is recognized when earned (regardless of when it’s received), and expenses are recognized when incurred (not necessarily when they’re paid).
This methodology matches revenue to the corresponding expenses in the proper period. Compared to the cash and tax methods, the accrual method helps you more accurately evaluate growth and profit margins over time and against competitors.
Using the accrual method also can help you manage cash flow. For example, with more timely financial data, you can negotiate payment terms with suppliers, plan for significant expenses and forecast future cash needs.
What’s right for your business?
Choosing the right accounting method for your business depends on your financial needs and accounting skills. Some businesses use a hybrid approach incorporating elements from two or more methods. The method you’ve used in the past may not be appropriate for your current situation.
Contact us to help you find the optimal approach.
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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.