While certain companies are obligated to use accrual-based accounting, many small businesses have a choice between the two. Continue reading below as we explore what each of these accounting methods is and the pros and cons of each to help make your decision.
Cash accounting, sometimes called cash-basis or cash-based accounting, is a method of reporting revenues and expenses when the cash inflow or outflow takes place, not necessarily when they are earned or incurred.
This is a common method individuals and many small businesses use when managing their personal finances because it’s generally seen as simpler. When cash enters the bank account, it’s considered income, and when cash leaves, it’s considered an expense.
With cash accounting, businesses do not use accounts payable or accounts receivable.
Cash-based accounting has some advantages and disadvantages, including:
To better understand what cash-based accounting looks like in practice, let’s review a real-world example.
Let’s say a small marketing agency is hired to handle email campaigns on behalf of an ecommerce store. They sign the contract and complete the work in December of 2023. However, the agency does not send an invoice for the work until January 2024, and the ecommerce store pays it a week later.
In this case, if the marketing agency is using cash accounting, they will report the income in the 2024 tax year, not in 2023 when they technically earned the revenue.
The same applies to recording expenses. If the same marketing agency hires a law consultant to create new contracts for them at the end of the year, but they don’t pay them until the next year begins, the expense will be recorded the following year when the cash actually leaves their account.
Accrual accounting, also called accrual-basis or accrual-based accounting, is a method where you report expenses and revenues when you earn them, even if you haven’t had a cash inflow or outflow yet.
Thus, it doesn’t matter when you make or receive a payment; it only matters when revenue is earned or an expense is incurred. So, even if they purchase goods on credit, it’s considered an expense when they make the order.
Companies that prepare financial statements in accordance with generally accepted accounting practices (GAAP), like publicly traded companies, will use the accrual method.
As with cash-based accounting, there are some pros and cons associated with the accrual method, such as:
To explore the accrual method in more detail, let’s use the above example of the marketing agency. This time, they use the accrual method of accounting to track revenues and expenses.
When they are hired to manage email marketing and complete the work in December 2023, the revenue is recognized for this tax year. Even though they do not receive the payment for their work until the next year, the accrual method states it must be reported in the same period it is earned.
On the other hand, they can also record the expenses they incurred in hiring the law consultant for the same period. This can positively impact their tax liability for 2023, even if they don’t pay the consultant until the beginning of 2024.
If you’re trying to decide on which method is the best for your business, review this head-to-head comparison of cash vs. accrual accounting to help clarify the major differences between them:
After reviewing the pros and cons of cash vs. accrual accounting and seeing how these two methods look in real-life scenarios, you may have a better idea of which method is right for your business.
Keep in mind the IRS provides some general requirements in Publication 538 when companies must use certain accounting methods, which may dictate your decision. This includes:
The IRS even states that companies can use a “hybrid” accounting system with a mixture of cash and accrual methods as long as they do so consistently.
Luckily, if you outsource finance and accounting matters to an experienced team like Bob’s Bookkeepers, you don’t have to concern yourself over which accounting method to use and when a revenue or expense can be properly recorded.
If you want to speak with an expert to decide the right accounting method for your business, contact us today.
