When it comes to running a business, you take on the role of decision-maker. And, one of your biggest decisions is if you should use cash or accrual accounting. What’s the difference? How in the world does accrual or cash accounting impact your books? We’re gonna break it all down for you.
Cash or accrual accounting method
Cash or accrual accounting? That is the question (that many new business owners need to ask themselves). Which one is right for your company? Are you required to use a certain method? What are the advantages and disadvantages of each?
Take a deep look at how they differ below. Then, find out what to consider when asking yourself, Should I use accrual or cash accounting?
Cash and accrual accounting definitions
When it comes to cash-basis and accrual accounting, how you record transactions in your books can vary. Let’s take a look.
Cash-basis accounting is the easiest accounting method. With cash accounting, record income when you physically receive it and expenses when you physically pay it. And, you use single-entry bookkeeping where you record one entry for every transaction.
Accrual is more complex than cash basis. If you use the accrual method, you must record income and expenses whenever a transaction takes place, even if you don’t physically receive or pay. And, you use double-entry accounting where you equally record a transaction in two or more accounts using debits and credits.
Cash basis vs. accrual accounts
Remember when we said cash-basis accounting is simpler than accrual accounting? That statement has a lot to do with the types of accounts you use with cash basis.
Cash-basis accounting lives up to its name by only using cash accounts. It does not use long-term liability accounts, inventory, accounts payable, or accounts receivable.
On the other hand, you can use more advanced accounts with accrual accounting, like accounts payable, accounts receivable, and inventory.
Accrual or cash accounting: Pros and cons
Both accrual and cash-basis accounting come with their own advantages and disadvantages. Let’s take a look at the perks and downsides of each, shall we?
| Cash-basis Accounting | Accrual Accounting | |
|---|---|---|
| Pros | -Easy to use -Fewer accounts -Ideal for small businesses -Simple to maintain -Less information to track -Less accounting knowledge needed | -Gives you accurate snapshot of your cash flow -Shows you clear picture of income and expenses -Better long-term financial view -Option to defer income on tax return for tax break -Good option if your business grows over time |
| Cons | -Not all businesses can use it -Doesn’t show you the full picture of income and expenses -Can’t use this method if your company grows -Can be difficult to switch to another method from cash basis | -More complex -Additional accounts -More accounting knowledge needed -Time-consuming for beginners -Doesn’t show clear image of cash on hand |
Legal requirements for cash and accrual accounting
There are some businesses that can’t use cash-basis accounting. And, some businesses can’t use cash basis as the company grows.
The IRS restricts which businesses can use cash basis to record transactions. If your company meets any of the following conditions, you cannot use cash-basis accounting:
- You are a corporation (not an S Corp) with average annual gross receipts for the three preceding tax years exceeding $25 million
- You are a partnership with a corporation (not an S Corp) as a partner with average annual gross receipts for the three preceding tax years exceeding $25 million
- You operate as a tax shelter
You also cannot use cash-basis if you sell goods or services on credit or need business inventory to account for income.
Generally, if your business meets any of the above conditions, you must use accrual accounting instead of cash basis. Use cash-basis accounting and meet one of the above? You can switch accounting methods using IRS Form 3115, Application for Change in Accounting Method.
Should I use cash or accrual accounting? 4 Questions to consider
Now that you know the difference between cash and accrual accounting, you can determine which method your business can use. Ask yourself these four questions before making a decision.
1. Am I required by the IRS to use accrual accounting?
First and foremost, ask yourself which accounting method you can use. Are you able to use cash basis? Or, are you required to use accrual based on IRS requirements?
If you’re unsure if your business meets the conditions to use accrual accounting, do your research. Find out if your business is required to use one method or another if you:
- Are a corporation or partnership
- Operate as a tax shelter
- Have gross receipts exceeding $25 million for the three preceding tax years
- Sell good or services on credit
- Need inventory to account for income
Consider also consulting an accounting professional if you are on the fence about which accounting method you need to use.
2. How much accounting experience do I have?
If you’re not required to use a certain accounting method, then you can go ahead with either option (woohoo!). But before you dive into one method or another, you should consider what kind of learning curve the method has.
Because cash basis uses fewer accounts and is simpler, it can be easier to pick up on for business owners. Not to mention, it is less time-consuming than using the accrual method.
If you’re willing to learn how to use more complex accounts or already have some accounting knowledge, accrual accounting may be a better fit for you.
So before you decide on a method, ask yourself:
- How much accounting knowledge and experience do I have?
- Do I have time to learn a more complex accounting method?
- What kind of learning curve does the method have?
The last thing you want to do is dive right into a method that’s too complex for your business and that you do not have time to learn. Weigh your options beforehand to avoid stressing out about your books and making accounting errors.
3. Will my business grow in the next few years?
Do you anticipate business growth in the next few years? If so, you may want to lean toward the accrual accounting route.
Businesses can outgrow accounting methods just like they can outgrow buildings when they hire additional employees. At some point, your business may become too large for the cash-basis method. And if that happens, you need to change from cash to accrual.
So before you choose the cash method of accounting, determine how much growth your business will have over the next few years. If you think you’ll outgrow the cash method, consider going with the accrual method to save you time in the long run.
4. How complex is my business?
Last but not least, consider the complexity of your business before making a decision on your accounting method.
Look at things like the size of your business, how many employees you have, your industry, and your number of accounts. If your business is complex and growing at a rapid pace, you may want to steer clear of using cash-basis accounting and go with accrual instead. That way, you can see the big picture of your business’s books and finances.
This is not intended as legal advice; for more information, please click here.