Business is great: you’re growing, generating profits, and hiring more employees. You’re establishing a finance and accounting department to manage your forecasting, budgeting, and month-end close. But you still have a critical decision to make — which accounting method to use?Your choice of accounting method affects how you record income and expense and impacts your overall financial reporting. Each accounting methods can lead to different tax consequences as well.Fortunately, you only have two methods to choose from:
- Cash Basis
- Accrual Basis
Let’s explore each one below so you can determine which method will work best for your business.
What is Cash Basis Accounting?
Cash Basis is the simpler of the two accounting methods — you record income only when you receive the money, and you record expenses only when the money leaves your hands.
For example, say you run a small accounting firm.
Your two clients are Client A and Client B.
Client A sends you a check for $2,000 for accounting services performed.
At the same time, you send Client B a $3,000 invoice for services you recently completed.
Additionally, you receive a $1,000 rent bill from your landlord for the office space your firm leases — the landlord sends you the bill one week before rent is due, so you don’t pay this yet. On top of that, you pay your electric bill — that you received a week ago — of $500.
Under the Cash Basis, you would record income of $2,000 and expenses of $500 for the month.
This is because Client A paid you, and you paid your electric bill.
You were billed for rent, but you haven’t paid it yet.
Additionally, Client B didn’t pay you. That is why you exclude those amounts.
What is Accrual Basis Accounting?
Accrual Basis accounting is more complicated. You record income when you earn it — meaning when you send out the invoice. You record expenses when you incur them — when you receive the bill.
Back to the above example, we’d record $5,000 total income and $1,500 total expenses because the Accrual Basis counts invoices and bills whether or not they’ve been paid.
The Pros of Cash Basis Accounting
One of the Cash Basis’s main benefits is its simplicity. Tracking your money is easy when you rely on the receipt or disbursement of cash to determine income and expenses. You’ll also have a clearer picture of the amount of cash you have available.
The Cash Basis can also provide tax benefits to small businesses, as you only record income later — when you receive the money, not the invoice.
The Cons of Cash Basis Accounting
Tracking Incoming and Outgoing Funds
Cash Basis accounting can make it harder to track incoming and outgoing funds, as you have no accounts receivables and payables. If you send an invoice or receive a bill, you’ll have to refer to either document.
The IRS requires you to switch to accrual after surpassing $25 million in revenue. Changing accounting methods during a period of rapid growth can cost you valuable time and money.
Private equity firms and banks have lending requirements that generally make it more difficult for Cash Basis business to obtain funding.
The Pros of Accrual Accounting
First of all, you are legally required by the IRS to use the accrual basis if your business earns at least $25 million per year in revenue.
But if your business earns less than $25 million, there are still other benefits to be had from the accrual method.
Clear Financial Picture
The accrual basis paints a clear financial picture of your profitability, as it includes accounts receivables and payables.
For example, let’s say you run a company that sells textbooks to college/university bookstores. Your busiest times of year will likely be late July/early August (for the fall semester) and late November/early December (for the winter semester).
Your customers (the educational institutions) buy the textbooks on credit, paying in September and January.
Under the cash basis, your busiest months would appear to be January and September because that’s when you receive the cash.
But using the accrual basis, you’d correctly recognize your busiest months to be July/August and November/December.
Banks and private equity generally require borrowers to operate their accounting on an accrual basis.
The Cons of Accrual Accounting
Accrual accounting does not track cash flows, so you won’t know precisely how much cash you have available.
You could have high income on your financial statements, but you could run into serious financial issues if you rely on these numbers to make certain financial decisions.
Accrual accounting is more complicated — and thus costlier — to implement.
The issue of complexity might be worse if you started out using the cash basis. Switching to a new accounting method while you already have systems in place for the old method isn’t easy — especially if you’re growing fast.
This goes back to cash flows. Since you must record income when you send out the invoice — not when you get paid — you may owe taxes on money you haven’t yet received.
Which Accounting Method is Best for My Business?
Each accounting method has its merits. The best method for you will depend on your company.
New businesses will fare well under the cash basis. The simplicity of this method saves you time and money that you can put towards growth. Plus, you can more easily track how much cash you have on hand.
However, if you experience rapid growth, you may want to switch to the accrual method sooner rather than later to prepare for GAAP rules. The smaller your company at the time that you switch methods, the easier the new method will be to implement.
Remember that if you plan on switching to the accrual method, the IRS only lets you make the change at the end of the year.
If you need help with your accounting, CFO Hub may be the right fit for your business. Contact us for a free no-obligation consultation today!