As a small business owner, keeping an accurate account of your expenses is vital if you’re going to keep your business in the black, and it’s absolutely essential if you’re going to grow. We understand that although you may be passionate about your business, you may not be passionate about accounting. But never fear.
The good news is that there are only two primary methods you’ll need to know: cash basis accounting and accrual basis accounting. Even if you don’t handle your own financial reporting, it’s vital to know how each one works so you can choose the best bookkeeping practices for your business. Below, you’ll find an overview of the two methods, updated with everything you need to know about the changes made by TCJA tax reform.
Cash vs. accrual accounting
While accounting might not be your favorite aspect of being your own boss, it’s still important to understand at least the basics and best practices of small business accounting. As long as your sales are less than $25 million per year, you’re free to use either the cash or accrual method of accounting.
Why would you choose one over the other? We’ll explain the basics of the cash and accrual accounting methods, as well as the pros and cons of each, so that you can make an informed decision.
What is the cash method?
First, we’ll start with the simpler of the two methods: cash basis accounting. With this method, you record income as it’s received and expenses as they’re paid. For example, if you invoice a client for $1,000 on March 1 and receive payment on April 15, you would record the income as received for the month of April. This is when you actually had the money in hand.
It’s important to note that this method does not take into account any accounts receivable or payable. This is because it only applies to payments from clients — whether in the form of cash, checks, or credit card receipts — when payment is received.
Likewise, cash accounting only records your expenses when money leaves your account to pay expenses to suppliers, vendors, and other third parties. In other words, if you have a small gift card and stationery business that purchased paper supplies on credit in June, but didn’t actually pay the bill until July, you would record those supplies as a July expense.
If your business makes less than $25 million in sales a year and does not sell merchandise directly to consumers, the cash accounting method might be the best choice for you. In fact, it’s often the accounting method of choice for very small businesses, such as sole-proprietorships or partnerships.
Advantages of cash accounting
The cash accounting method certainly has its benefits. The chief among those being ease of use and improved cash flow.
Many small business owners choose the cash method of accounting because it’s a simplified bookkeeping process that is similar to how you might track your personal finances. It’s easy to track money as it moves in and out of your bank accounts because there’s no need to record receivables or payables.
For small companies that do business primarily through cash transactions and do not maintain large inventories of product, the cash accounting method can be a convenient and reliable way to keep tabs on revenue and expenses without the need for a great deal of bookkeeping.
When it comes to taxes, cash basis accounting has definite perks. With this method, you don’t have to pay taxes on any money that has not yet been received. For instance, if you invoice a client or customer for $1,000 in October and don’t get paid until January, you wouldn’t have to pay taxes on the income until January the following year.
This helps improve cash flow and helps ensure that your small business has funds available for tax payments. For individuals and extremely small businesses, this can be crucial to keeping your business afloat when cash flow is restricted.
Disadvantages of cash accounting
While the cash method of accounting is definitely the simpler of the two most common accounting methods, it has its drawbacks as well.
Inaccurate financial picture
Since it doesn’t account for all incoming revenue or outgoing expenses, the cash accounting method can lead you to believe you’re having a very high cash-flow month when in actuality this is a result of a previous month’s work.
No accounts receivable or accounts payable records
Additionally, because the method is so simple, it does not require your accountant or bookkeeper to keep track of the actual dates corresponding to specific sales or purchases. In other words, there are no records of accounts receivable or accounts payable, which can create difficulties when your company does not receive immediate payment or has outstanding bills.
Doesn’t conform to Generally Accepted Accounting Principles or GAAP
The Generally Accepted Accounting Principles, or GAAP, are the standard framework of rules and guidelines that accountants must adhere to when preparing a business’s financial statements in the United States. Under these guidelines, all companies with sales of over $25 million must use the accrual method when bookkeeping and reporting their financial performance. This means that if your business were to grow larger than $25 million in sales, you would need to update your accounting practices. If you think your business could exceed $25 million in sales in the near future, you might want to consider opting for the accrual accounting method when you’re setting up your accounting system.
What is the accrual method?
Accounting standards outlined by the Generally Accepted Accounting Principles (GAAP) stipulate the use of accrual accounting for financial reporting, as it provides a clearer picture of a company’s overall finances.
But just what is this method?
With the accrual accounting method, income and expenses are recorded when they’re billed and earned, regardless of when the money is actually received. For instance, using the example from above, if a small business bills $1,000 in income on March 1, you would record that $1,000 as income in March’s bookkeeping — even if the funds didn’t clear your account until April 15.
The same holds true for expenses. In this case, if your small gift card and stationery business buys paper supplies on a credit in June, but doesn’t actually pay that bill until July, you would still record that as a June expense.
Advantages of accrual accounting
Unlike cash accounting, which provides a clear short-term vision of a company’s financial situation, accrual accounting lets you see a more long-term view of how your company is faring.
This is because accrual accounting accurately shows how much money you earned and spent within a specified time period, providing a clearer gauge of when business speeds up and slows down over the course of a business quarter or a full year. Additionally, it conforms to nationally accepted accounting standards. This means that if your business were to grow, its accounting method would not need to change.
More accurate financial picture
Although this method requires more intensive bookkeeping, it gives small business owners a more realistic idea of income and expenses during a certain period of time. This can provide you (and your accountant) with a better overall understanding of consumer spending habits and allow you to plan better for peak months of operation.
Conforms to GAAP
Because the accrual method conforms to the Generally Accepted Accounting Principles (GAAP), it must be used by all companies with more than $25 million in annual sales.
As the $25 million sales revenue mark is high for most small businesses, most will only choose to use the accrual accounting method if their bank requires it.
Disadvantages of accrual accounting
While accrual accounting has its advantages, there are some drawbacks as well. Among the most commonly cited is its more complex method of bookkeeping and its inaccurate portrayal of a company’s short-term financial situation.
Because accrual accounting adds complexity and paperwork to your financial reporting process, many small business owners view it as more complicated and expensive to implement. Since a company records revenues before they actually receive cash, the cash flow has to be tracked separately to ensure you can cover bills from month to month.
Inaccurate short-term view
While the accrual basis of accounting provides a better long-term view of your finances, the cash method gives you a better picture of the funds in your bank account. This is because the accrual method accounts for money that’s yet to come in.
As a result, if you don’t have careful bookkeeping practices, the accrual-based accounting method could be financially devastating for a small business owner. Your books could show a large amount of revenue when your bank account is completely empty.
How to choose the right option for your business
While the accounting system and financial reporting method you choose for your small business is ultimately a management decision, it also depends on your business goals, the resources you have available, and your organization’s financial requirements.
Unless your company makes more than $25 million in gross annual sales, you’re free to adopt whichever method makes more sense for you.
However, keep in mind that the IRS requires companies to use and maintain the same accounting method to report taxable income for a year — so no changing halfway through the tax year.
Some small businesses can choose the hybrid method of accounting, wherein they use accrual accounting for inventory and the cash method for their income and expenses. If you’re unsure of which accounting method is best for your small business, speak with a CPA or tax professional. For more accounting tips, check out our accounting checklist for finance-related tasks you must complete on a daily, weekly, monthly, and yearly basis.