Cash-Basis vs Accrual-Basis Accounting: Which is Best For My Business
No business can function without some method of accounting. But how do you know which method to use? The answer depends on the size of your business and the kinds of transactions it will engage in.
Which Accounting Method Should I Use?
No business can function without some method of accounting. But how do you know which method to use? The answer depends on the size of your business and the kinds of transactions it will engage in. While it is possible to change accounting methods later, it is crucial to make the right decision when starting to ensure that you have a complete picture of your business's financial health.
What Is Cash-Basis Accounting?
Cash-basis accounting is exactly as the name sounds: it follows the principle of recording revenues and expenses when cash is received or paid. When you receive cash, revenue is reported on the income statement in the amount you have received, and when you pay cash, expenses are recorded on the income in the amount you paid.
For example, say you own a small hot dog stand that sells hot dogs and other food items. Suppose you were to follow the cash-basis accounting method, every time a customer pays you $5 for a hot dog, that $5 is recorded as revenue in the income statement. On the expense side, when you purchase $100 worth of hot dogs and buns and hand over $100 to the wholesaler, you record $100 in expenses.
What Is Accrual-Basis Accounting?
Accrual-basis accounting is a little less simple. This accounting method focuses on when the transaction happens, regardless of whether cash is exchanged. Revenue is reported when it is earned, and expenses are recorded when they are incurred. Revenue is earned when products are delivered to the customer or services are provided, and when there is a reasonable expectation that the customer will pay cash. Expenses follow the matching principle, which means that expenses are recorded in the same accounting period in which the related revenue is recognized. Put another way, accrual-basis accounting takes into consideration accounts receivable and accounts payable.
Going back to our hot dog stand example, say one day a regular customer comes to buy a hot dog but realizes she forgot her wallet at work. Because you see her almost every day and trust her, you give her the hot dog and say she can pay you back tomorrow. She agrees and walks away with the hot dog. If you were using cash-basis accounting, nothing would happen to the income statement because cash was not exchanged in the transaction. However, when using the accrual-basis method, you would record $5 in revenue because the product, the hot dog, was delivered to the customer. There is a reasonable expectation that your loyal customer will pay you back. According to the matching principle, the cost of goods sold, which is the hot dog's cost and the bun, is added to the expenses.
Pros and Cons of Cash-Basis and Accrual-Basis Accounting
The main difference between the two methods of accounting lies in the timing. Cash-basis accounting follows exactly the receipt and payment of cash, whereas accrual-basis accounting completely ignores it and focuses on the performance of obligations.
Accounting For Beginners : Cash vs Accrual Accounting
Many solopreneurs and small business owners start out using cash-basis accounting simply because it is easy and cost-effective for a business that is just starting! All you need is an Excel spreadsheet, and you're ready to begin accounting. Because cash-basis accounting only looks at actual cash exchanged, there is no need to complicate the accounting with accounts receivable or accounts payable. The only thing that needs to be tracked is cash, which is fine because cash is king! This is especially true for a small business whose cash is the bloodline of the company. There also may be tax benefits because you don't have to pay taxes on unpaid but earned revenue until it is received. For example, if you sell goods in November of 2019 that are not paid for until February of 2020, you can push back the taxes to 2020, the year that the money is actually paid. However, the same goes for purchasing on credit. If you are buying goods in November of 2019 that are not paid for until February of 2020, you also push back the expense deductions to 2020.
The simplicity of cash-basis accounting also contributes to its weaknesses, however. While cash is significant, cash may not follow revenue a lot of the time, especially if the business often sells and purchases on credit. When accounts receivable and accounts payable are not considered, the accounting may present a very misleading picture of the company's profitability and future cash flows. This is especially true if you're relying on accounting to provide a snapshot into the financial health of a particular time. Moreover, cash-basis accounting is not acceptable under GAAP (Generally Accepted Accounting Principles) or IFRS (International Financial Reporting Standards). Being not acceptable under those two methods is why some business owners may need to hire a CPA to convert their accounting later on if they seek financing or investors.
While cash-basis accounting may lack accuracy, accrual-basis accounting is much more accurate in tracking revenues and expenses because it considers outstanding invoices. Though accrual-basis accounting is excellent at providing a more comprehensive understanding of your financial position, this additional information comes at the cost of more time and resources expended on accounting. Due to the complexity of accrual-basis accounting, many businesses that use it employ a CPA or, at the very least, buy specialized accounting software to make it manageable. Additionally, because accrual-basis accounting does not track cash flow, you should be mindful of the cash flow statement to gain a fuller picture of your business's financial position.
Should Small Business Owners Use Cash-Basis or Accrual-Basis Accounting?
Small businesses have the option of using either cash-basis or accrual-basis accounting for tax purposes. The IRS mandates that a corporation (other than an S corporation) with average annual gross receipts above $25 million cannot opt for cash-basis accounting. If that does not apply to you, then the IRS allows you to use cash-basis accounting. But even if you're allowed to, should you?
Generally speaking, small businesses that do not deal with massive amounts of inventory and are mostly cash-based should use cash-basis accounting simply because it is easier. Our small hot dog stand is a great example – if most or all of the stand's customers pay in cash, and all the transactions center around buying hot dog supplies and selling hot dogs, cash-basis accounting will probably be both easier and more efficient. If your business begins to scale up in size and profitability, then at a certain point, it may be more appropriate to switch to accrual-basis accounting. For example, if the hot dog stand turns into a hot dog restaurant (or even a chain of restaurants), now there will be more inventory, more transactions, more supplies. More hot dogs will probably be bought and sold on credit, meaning accrual-basis accounting can make it easier to accurately keep track of the business's financial health. And when it comes time to find investors to help take the hot dog chain global, they will demand financial statements up to GAAP or IFRS standards.
Deciding which accounting method to use will inevitably require critical decision-making and analysis of your circumstances. Still, by reading this article, you are one step closer to making an informed decision!
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