As a small business owner, it’s important to keep track of your business income and expenses and pay taxes on your profits. These might not be your favorite aspects of entrepreneurship, but they’re essential for keeping your business in the black and ensuring you don’t get into trouble with the IRS.
One of the first decisions you have to make regarding your business financials is whether you will use the cash basis or accrual basis. Each has its pros and cons. Here’s how to decide which one is right for you, and what it means for your financial statements and the amount of tax you owe.
Cash Basis Accounting vs Accrual Basis Accounting—What’s the Difference?
Under the cash basis of accounting, your business records income in its books when cash is received and expenses when they are paid. Using cash basis accounting doesn’t require the use of:
- Accounts receivable. An account used to track money owed to your company for goods or services provided to customers on credit.
- Accounts payable. An account used to track money owed to other companies, typically for purchases of goods and services.
Under accrual basis accounting, revenues and expenses are recorded when they are earned, regardless of when money actually changes hands. Using the accrual basis means you need to include accounts receivable and accounts payable in your chart of accounts.
To illustrate the difference, say you complete a project for a client on December 27, 2021, and send them an invoice for $600. Your client pays the invoice on January 5, 2022. At the end of the year, you’ve earned that $600 of revenue, but haven’t yet been paid.
If you keep your books on the cash basis method, you would record $600 of revenue on your books in January 2022—the year you received payment. If you keep your books on the accrual basis, you would record $600 of revenue in 2021—the year you earned it. Your December 31, 2021, balance sheet would include accounts receivable of $600.
Likewise, say you order $200 of office supplies on credit in December of 2021, but don’t pay the accompanying invoice until January 2022. Under the cash basis of accounting, you would record that expense in January because that’s when the money changes hands. However, if you use the accrual basis of accounting, you recognize that expense in 2021 and your December 31, 2021, year-end balance sheet would include $200 of accounts payable.
Cash vs Accrual: Which Is Better?
Your business can choose between the cash or accrual basis as long as:
- It averaged less than $25 million in sales over the past three years
- Your business doesn’t maintain product inventory or offer store credit to customers
- Your business isn’t publicly traded
If your sales are greater than $25 million, you have inventory or offer store credit, or are planning to go public, you’re required to use the accrual basis.
Let’s consider the pros and cons of each.
Pros and Cons of Cash Accounting
The cash basis of accounting is used by many small businesses because it’s simpler. You don’t have to deal with accounts receivable or accounts payable. You simply record income as it’s received and expenses as they’re paid.
The cash method also gives you more control over when you pay income taxes on your revenues because you don’t have to pay tax on income until it’s actually received.
However, there are some disadvantages to using the cash method of accounting. Because you don’t recognize receivables and payables on your company’s books, the cash method can offer a distorted view of your financial standing. Also, because the cash basis doesn’t match revenues to expenses, timing differences can make it seem as though your business has sporadic revenues or isn’t financially viable in certain periods.
Pros and Cons of Accrual Accounting
There are some advantages to using the accrual method, even when it’s not required. Because this method matches revenues and expenses to the time period in which they occurred, it provides a more accurate picture of your company’s profitability and financial health. That’s why this method is required for publicly traded companies and businesses that issue financial statements using Generally Accepted Accounting Principles (GAAP).
Accrual accounting is more complex, but a reputable accounting system can handle a lot of the heavy lifting of recording receivables and payables for you.
Besides the increased complexity of using the accrual basis of accounting, another downside is that it’s tougher to keep an eye on the amount of cash you actually have available. Because the accrual method requires you to recognize revenues when earned, your financial statements may show healthy revenues even though the business is experiencing a cash shortage because a significant amount of revenues haven’t actually been received yet—it’s stuck in your accounts receivables.
Companies Likely to Use the Cash Basis
- A landscaping company with average annual gross receipts of $65,000 that carries only a small inventory of sprinkler parts
- A real estate agent who works as an independent contractor and earns roughly $1 million per year in gross commissions
- A mobile dog groomer with average annual gross receipts of $35,000 and a small inventory of cleaning supplies and dog treats
Companies Likely to Use the Accrual Basis
- A technology startup that plans to go public within the next few years
- A furniture store with significant inventories
- A media company whose stock is traded on the New York Stock Exchange
- A real estate developer with average gross annual receipts of $35 million
Accrual Basis for Books, Cash Basis for Tax
If your business does not store inventory, it’s possible to get the best of both worlds: using the accrual method of accounting for bookkeeping and the cash basis for tax purposes.
To do this, you maintain your books on an accrual basis by recording receivables when you earn income and payables when you incur expenses, regardless of when cash enters or leaves your bank account. Then, when you prepare your tax return, your accountant or bookkeeper will convert your books to the cash basis by:
- Adding accounts payable back to profits
- Subtracting accounts receivable from profits
You don’t actually enter these changes into your company’s accounting records. Instead, your bookkeeper or CPA will likely prepare the accrual to cash conversion in a spreadsheet or accounting software. Then, when they prepare your business tax return, they’ll show the differences between your company’s book income and taxable income on Schedule M-1 of your business tax return.
For an example of how this might work in real life, let’s say you keep your books on the accrual basis method, and your December 31, 2021, balance sheet and income statement show the following amounts:
- Net income of $100,000
- Receivables of $15,000
- Payables of $5,000
Your cash to accrual conversion would look like this: