As a small business owner, you’ll need to implement an accounting method to track your revenue and expenses and calculate your profit. With an effective accounting method in place, you can figure out what cash you have available at any point during the year, explains Yves-Marc Courtines, CFA and principal at Boundless Advice. We talked to Courtines to explain the difference between cash vs. accrual accounting and help you figure out which system is better for your small business.
Cash vs. Accrual Accounting
So what exactly is the difference between these two methods?
Cash accounting allows you to document and record revenue or expenses only when cash comes into or out of your possession, explains Courtines. In other words, sales are recognized when cash is received from clients or customers, and expenses are recognized when payments are made to vendors or suppliers.
Note that by “receipt of cash” we mean cash, checks, credit cards, Venmo payments, Square transactions, Zelle transfers and so forth. Courtines also points out that according to the IRS, “cash received” can also include items of value — like giving your Uber driver a $5 gift card instead of physical cash or an in-app tip.
Accrual accounting, on the other hand, means you record inbound transactions when you invoice clients and outbound payments when vendors request payment from you. Instead of tracking physical cash flow, an accrual system matches the income or expense with when the product or service was provided to the customer. Even if no cash has been received from the customer (or an expense has been invoiced but not paid to the vendor), the revenue is documented.
Which Accounting System Is Right for Your Small Business?
The short answer? It depends. Most small businesses with no inventory use the cash accounting method because it’s simpler, explains Courtines. In his experience, many small businesses of this type find it easier and faster to keep records using cash accounting. Cash accounting is also simpler to complete on IRS forms.
Cash accounting provides an accurate picture of your business financials at a snapshot in time. However, accrual accounting gives you a better sense of whether these numbers are reliable and repeatable for the foreseeable future, explains Courtines. The accrual method also offers a more accurate, real-time picture of how your business is performing each month.
“If your business is growing steadily, or if your business is based on a recurring service with little fluctuation and few issues getting paid by clients, cash basis accounting will likely be straightforward and sufficient,” says Courtines.
He also lists some situations in which the accrual method might be more accurate instead:
- Your business has significant inventory
- Vendor payments fluctuate greatly from month to month
- Some customers pay quickly but others stretch out payments for months
How Being Incorporated Affects Which Method You Use
If you’ve set up your business structure as an LLC, C Corp or S Corp, the IRS will ask you which method of accounting you’ve chosen in your first year of incorporation for tax purposes, explains Courtines. Once you pass $5 million in annual sales and are taxed as a C Corp or a partnership, you must use the accrual accounting method.
The IRS also indicates that certain businesses must use accrual accounting. For instance, if you cross $5 million in annual revenue or if your business sells goods and needs to keep track of inventory. (There are some exceptions, so you’ll want to look into this thoroughly.)
One simple exception is if you have an S Corp or run a business (regardless of structure) that’s service-based. So graphic designers, content strategists or architects, for example, can continue to use cash accounting even on the lucky day when they pass $5 million in annual revenue!
At tax time, most businesses can choose their accounting method when they file their first tax return. You can also ask permission from the IRS to change it in subsequent filings.
Another approach? You could run accrual accounting in your software to manage the business finances from the start. But if you hate the idea of paying Uncle Sam based on cash that’s not yet in your hands, you could ask your accountant to make a few year-end adjustments and then file under the cash method, says Courtines.
Carefully weighing the pros and cons of cash vs. accrual accounting and learning about each method’s caveats will help you gauge which is a better fit for your small business. If you find that you’re having trouble deciding, reach out to Incfile! We’re here to help, and can even file your business taxes for you.