When businesses are formed and start filing taxes, they must pick a specific accounting method. Businesses generally choose between the cash accounting method (also called cash basis accounting) and the accrual accounting method (also called accrual basis accounting).
Once a business chooses its accounting method, it has to use this accounting method for all years going forward. The reason for this should become clear when you understand the differences between the two methods. So what exactly are the differences between cash accounting and accrual accounting?
The vast majority of self-employed individuals (sole proprietors) and many small businesses opt for cash accounting because it’s relatively simpler that other accounting methods. Cash accounting works like this:
- Revenues are recorded when cash comes in
- Expenses are recorded when they are paid
- No need to track payables and receivables
Cash accounting makes it easy to see the flow of cash in and out of your bank account. You always know exactly how much cash you have on hand.
Additionally, when tax time rolls around, cash accounting is great for end-of-year tax calculations. You don’t pay taxes on any income that’s still pending payment, but you earn the benefit of deducting expenses you’ve paid.
Accrual accounting is used by many small businesses but is especially favored by medium-sized and large businesses. Businesses that carry inventory are pretty much required to use accrual accounting. Accrual accounting works like this:
- Revenues and expenses are matched and recorded at the time a transaction occurs, regardless of when these are actually received or paid
- An inflowing transaction is recorded as a receivablein the current assets section of the balance sheet as soon as the work is completed or the invoice is sent
- An outflowing transaction, such as an expense for a good or service received on credit, is recorded no later than the date the good or service was received, and the transaction is recorded as an account payableunder the current liabilities section of the balance sheet
The big advantage of accrual accounting is that, because it combines current and expected cash flows in and out of the business, it provides a more accurate picture of the actual financial condition of the business. While this method does offer a better snapshot of overall finances, its relative complexity makes it more difficult to implement.
Hybrid Accounting Methods
It’s actually possible to employ a hybrid of cash and accrual accounting. So, for example, a business with inventory might use the accrual method for purchases and sales, while opting for the cash method for all other items of income and expenses.
Choosing the right accounting method can have large implications for your business success going forward. Consulting a knowledgeable tax professional to help you make that choice can be of major benefit to your business.