Cash or Accrual: which method is right for you?
The basics of accounting are essential for every business. That’s why we developed a Guide to Accounting. Over a series of posts, we highlight some of the key accounting concepts you need to be aware of, when an accountant can help, and how to find and work with an accountant.
In this part in the series we dive into a key question asked by many business owners: what’s the best method to record income, cash or accrual accounting?
Here’s what you need to know to make an informed decision.
What is the Cash Accounting Method?
Let’s start by defining the cash method of accounting. This is the most straightforward way to record your income and simply means that you record income as you are paid. For example, if you invoice a client on April 30th and they paid you on May 15th, you’d record the income on the latter date. Cash accounting is also known as the calendar year method.
But what happens if you invoice in November or December, but don’t receive payment until the next year? If you use the cash method, you’d record that income in the new calendar year, when you get paid and report it on that year’s tax return. With this method, expenses are also deducted in the tax year in which you pay them.
One complication of the cash accounting method is that it can skew your view of your books. If November and December are your busy season, you may not see that revenue on your books until the new year. Thus, to an uninformed eye it could appear that you are showing too little profit and a negative cash flow, when in fact your business is healthy.
The cash accounting method isn’t an option for everyone. The IRS lists exclusions that include corporations (other than an S Corporation) and partnerships with a corporation as a partner with gross receipts exceeding $5 million.
What is the Accrual Accounting Method?
Sold something today? If you use the accrual accounting method you can put that on the books when the sale took place, rather than waiting until you get paid (as with the cash accounting method). For example, a company provides landscaping services to a customer on May 5th and generates an invoice that day or even the next day, with the understanding that the customer will pay within 15 days. That revenue is recorded on the date of service.
While the accrual method provides a better snapshot of your earnings than the cash method, it could make it appear that you have more cash on hand than you do. This can be problematic if you’re experiencing short-term cash flow gaps so you’ll need to be diligent in maintaining and monitoring your cash flow forecast and cash flow statement for a truer picture of your cash situation.
Who can use the accrual method? Anyone can, however, the IRS mandates business’ to adopt accrual accounting if that company has more than $10 million in annual gross receipts
Which is better for your business?
Cash accounting can seem like the sensible way to go, especially for sole proprietors and LLCs who value simplicity in their accounting. With one caveat: the cash method doesn’t always fit with the complex business transactions that are common today. For example, most businesses operate on trade credit or net terms (30/60/90 days). The business may produce work as part of that agreement, long before it’s invoiced. So, 30 days of work is done before an invoice is issued, then another 30/60/90 days transpires before the invoice is paid.
If you use the cash accounting method that revenue is added to the books after 60 days from the original agreement (when payment is received). In the case of accrual accounting fans, the revenue is counted when the invoice is sent, but before cash is in hand.
Fortunately, accounting software (and your accountant) can provide accrual calculations so you don’t need to understand the ins and outs of what’s flowing in when. And, if you’re waiting on payments from clients on trade credit, consider reducing your exposure with Fundbox Pay.
When in doubt, seek the advice of an accountant, they can match you to the right accounting method based on your needs, time, and financial preferences.
Stay tuned for the next in this series where we’ll discuss what an accountant can do to help your business and what they can’t. Missed part one? Catch up here: 12 Accounting Terms Every Small Business Owner Should Know.
Note: Fundbox and its affiliates do not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.