Cash Basis Accounting Vs Accrual-Basis Accounting
For business owners, managing finances of a fast-growing small business can be difficult, and choosing the right accounting method is one of the critical early decisions to make. There are two main accounting methods used for keeping business records—cash-based and accrual-based. Generally, small businesses, sole proprietors, and individuals use cash-based accounting, whereas larger companies operate on an accrual basis. Per the IRS’s rules, you can’t switch accounting methods within a given tax year. This means that the end of the year is the ideal time to reevaluate your business’ accounting method and ensure that it aligns with your company’s goals as you head into the new year.
What’s the difference between cash and accrual?
The main difference between cash-based and accrual-based accounting boils down to the timing of recording expenses and revenues. In cash-based accounting, revenues are recorded when cash is received from a client, and expenses are recorded when money is paid out. For example, suppose that a construction business secures a large contract for a new apartment building, but will only receive payment for it once the project is complete. If the construction business is operating on a cash-basis, they’ll record that revenue only once the building is finished. They’ll similarly record expenses as they spend money while working on the project.
Accrual-based accounting records revenue when the sale occurs, even if payment has not been received. Expenses are also recorded when the bill is incurred, regardless of when the money is actually paid out. Returning to the same example above, on an accrual basis, the construction company would record the revenue when they secure the contract, even if they won’t receive payment for months.
Which method is preferable?
Both methods have benefits and limitations. Accrual-based accounting aligns with Generally Accepted Accounting Principles (GAAP), though cash-based is more simple and straightforward to maintain. While the first provides better long-term visibility into a business’ financial health, the latter is a good option for smaller businesses that may not have a large budget or team to dedicate to accounting. Additional pros and cons are listed below.
Pros of Cash-Based Accounting
- It’s simple to use. The cash method is easy to understand, particularly for business owners that have no prior experience managing the accounting side of their company. Transactions are recorded when cash flows in or out; the only thing needed is accounting software for small businesses.
- It provides a realistic picture of cash flow. Since the recording of revenues and expenses aligns with the timing of each, the business owner can always see how much cash the business has on-hand.
Cons of Cash-Based Accounting
- It doesn’t show the full picture. Since cash-based accounting doesn’t take into account the business’s liabilities, the owner can end up spending money that the business doesn’t actually have.
- It has restrictions. If the business sells products or services on credit, need inventory to account for income, or are a C-corporation, a cash-based method cannot be used.
Pros of Accrual-Based Accounting
- It’s more accurate. The accrual-based method takes into account receivables and liabilities, which paints a realistic picture of your company’s health and profitability.
- It’s scalable. As businesses grow, they’ll eventually convert to an accrual method, especially as their reporting needs become more advanced. Switching from cash to accrual can be highly difficult, so starting off with an accrual method early saves significant amounts of time down the line.
Cons of Accrual-Based Accounting
- It’s more complex. Unless the business owner has an accounting background, operating on an accrual-basis generally requires additional staff to be brought in.
- Income tax may be owned on revenue not yet received. If the business isn’t also monitoring and managing cash flow, this can create problems.
Making the Switch
For growing businesses, or business owners wanting long-term visibility into their financial health, it may be necessary to switch from cash-based to accrual-based. Making the switch, however, is no easy feat. Generally, accounting software that is designed to manage finances on a cash basis is not designed to handle accrual-basis accounting. This means that all conversion adjustments must be made manually.
Additionally, changing accounting methods requires formal approval of the IRS. A company wanting to make a change must file Form 3115 in duplicate and pay a fee. A copy should be attached to the taxpayer’s income tax return and the other copy must be sent to the IRS Commissioners.
If your cash-based business is considering making the switch to an accrual method, this is an excellent opportunity to bring in outsourced accounting support. A fractional accountant can help you implement the generally accepted accounting principles that an accrual method requires, as well as incorporate new maintenance processes and procedures. They can also train your existing accounting staff on operating the business on an accrual basis. Bringing in an expert can make the process go much more smoothly and efficiently, serving as an investment to the long-term success of your business.
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