Cash basis lets businesses record income and expenses only when cash is actually received or paid. Accrual accounting involves tracking income and expenses as they are incurred (when an invoice is sent or a bill received) instead of when money actually changes hands. Cash accounting is much simpler, but accrual is required for certain businesses and preferable for others to leverage certain tax strategies. Show Because of the differences between cash and accrual accounting, one method may be more appropriate for your business than the other. Luckily, most accounting software makes it easy to track your business’s finances with both cash basis and accrual methods. Keep in mind, however, that you must decide which method you want to use and then be consistent when tracking your income and expenses. Editor’s note: Looking for the right accounting software for your business? Fill out the below questionnaire to have our vendor partners contact you about your needs. Cash vs. accrual accountingCash and accrual accounting differ in a number of ways, but the main difference is when income and expenses are actually reflected in a business’s books. Businesses that are eligible to use cash accounting almost always prefer to use that method because it’s simpler and more straightforward. Because income and expenses are recorded at different times if a business is using cash or accrual accounting, this also impacts when businesses incur tax liability (or benefit) as a result of these transactions. For example, while businesses using cash accounting incur tax liability when funds from a sale hit their account, businesses using accrual accounting are taxed on sales made in a given year, whether or not those sales have been paid for. Cash vs. accrual at a glance
Pros and cons of cash basis accountingCash basis accounting is a method where revenue is recorded when the cash is actually received; likewise, expenses are recorded when they are paid. Cash accounting does not acknowledge or track accounts receivable or accounts payable. For that reason, the method is best for small businesses that do not stock inventory. Pros
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Pros and cons of accrual basis accountingUnder the accrual basis accounting method, income and expenses are recorded when they are accrued, not when the money actually comes in or goes out. Accrual basis is the more common method of accounting, and it’s mandatory for corporations that have gross receipts of $26 million or more in any of the past three years. Accrual accounting is also required for businesses that average more than $25 million in gross receipts over the last three years. [Read related article: How to Prepare an Income Statement] Key takeaway: Accrual accounting is ideal for larger businesses and inventory-based businesses that benefit from depreciation and credit sales.Pros
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Take, for example, a small retail business that completes the following transactions in one month:
Under the cash basis method of accounting, the business has $2,700 in profit for the month. This is because the $500 maintenance expense and $2,000 invoice are not included in the month’s accounting because the funds have not been spent or received. On the other hand, if the business uses accrual accounting, its books will reflect a profit of $4,200 for the month by including all of the income and expenses recorded during that time. [Read related article: How to Calculate Profit Margins] How to choose the right method for your businessThe best accounting method for your business depends on several factors. In general, cash accounting is best for small businesses and businesses that do not carry inventory as part of their operations. Alternatively, large businesses and inventory-based businesses should opt for accrual basis accounting. Small businesses that are expected to grow may also want to start with accrual basis accounting so they’re prepared for future accounting needs. Depending on what type of business you are, how much money you make, and the types of sales you make, you may not have a choice. The IRS requires certain businesses to use accrual basis accounting. For example, corporations other than S-corps must use accrual basis accounting if they averaged over $25 million in gross receipts over the past three years. Certain corporations and tax shelters – including those that make sales on credit – are also prohibited from using cash accounting. If you have the option of cash or accrual accounting, most top accounting software programs make it easy to choose the one you want to use for your business; some even provide guidance to determine which one will benefit you more. Top business accounting software
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