In Pursuit of Profit
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Small businesses with less than $25M in annual revenue can choose whether they prefer to use cash or accrual accounting. However, you must declare which you are using when filing business tax documents during formation and plan to stick with your choice for the foreseeable future. New businesses are often tripped up by which they should use because they do not truly understand the implications of each type of accounting.
What are the differences?
Are there advantages to using one over the other?
Do bookkeepers and accountants work with both?
The decision about which type of accounting system to use depends on size, payment terms, business goals, available resources, and third-party financial requirements. Management should consider all these factors before deciding and consult with a professional accountant as needed during the process.
Both cash and accrual accounting methods result in the same bottom line when all your accounts receivables are collected. The differences are when that revenue is recognized and what kind of tax obligation is incurred as a result.
With cash basis accounting, you record income when you receive it from customers and expenses when you pay them to suppliers, vendors, and service providers. Money is only accounted for when it is received and when it leaves.
Cash basis accounting is considered best for businesses that have little cash on hand, companies with simple transactions, and those that do not sell directly to consumers. Micro companies, sole proprietorships, and partnerships typically prefer to use cash accounting.
The Benefits of Using Cash Basis Accounting
The most significant benefit of using cash accounting is simplicity. It is easy to track and manage, even for people who are not as financially savvy because it mimics how personal finances are handled. With cash accounting, there is no need for you to keep track of accounts payable and accounts receivable. Its ease of use makes cash basis accounting better for companies that extend credit to their customers because it simplifies the process of tracking money coming into the business.
Cash accounting also results in better cash flow because you do not have to pay taxes on money that has not yet been received. This can make a significant difference when a customer is invoiced in December and pays in January, especially for cash strapped small businesses.
The Drawbacks of Using Cash Basis Accounting
Cash accounting does not provide an accurate long-term picture of your business’s finances, making it
a poor predictor of sustainability. Your company’s financial position can be misrepresented depending on when payments are received – underreporting months when work was done. Still, money has not yet been received, and overinflating months when invoices were paid to cover previous work done in previous months. Skewed data like this makes it difficult to spot trends and anticipate future spending.
Outstanding invoices are also harder to track, which can result in revenue loss when invoices become uncollectible and must be written off as bad debt.
When a business grows revenue past the $25M mark, it must change accounting practices because cash basis accounting does not comply with GAAP (Generally Accepted Accounting Principles). This switch is messy and difficult to manage because it requires that an IRS Form 3115 be filed, and some lengthy steps be taken to get approval from the IRS. In this situation, it is important to hire an accountant to manage the transition correctly.
The goal with accrual basis accounting is to match your revenue and expenses during the same period to provide a complete look at your company’s finances. Income is recorded when it is earned, and expenses are recorded when they are billed regardless of when money comes into and goes out of your business.
C corporations are required to use accrual accounting because it is GAAP compliant. Additionally, many banks will require that businesses use accrual accounting to receive financing.
The Benefits of Using Accrual Basis Accounting
Unlike cash accounting, which only provides a short-term view of your business’s finances, accrual accounting provides an accurate long-term picture of your company’s financial position. The result is a better financial analysis regarding seasonality and business trends, which in turn improves budgeting processes and strategic planning.
The Drawbacks of Using Accrual Basis Accounting
Accrual accounting is more complicated, which may necessitate hiring a full-time bookkeeper or accountant for the business. For companies looking to keep personnel expenses low, this is likely an unpopular idea.
Additionally, accrual basis accounting is not as focused on the short-term, which can be dangerous for businesses experiencing cash shortages or weathering market downturns because what is on the books may not necessarily correspond to what is in your bank account. Accounting professor Jerold Zimmerman explains, “In the accrual method, a company's recordkeeping might indicate soaring revenues when, in reality, its bank account is empty. While the accounting may be technically accurate, the owner might be surprised to learn that he can't make payroll.”
Lastly, accrual accounting can affect tax reporting because income taxes can be incurred before the income has been received. This may not be a big deal for larger companies, but it can create a troublesome burden for small businesses.
It is possible to take a hybrid approach to combine the best of both methods - using cash accounting for income and expenses and accrual for inventory. Your accountant can advise on which method is best for your unique circumstances.
If you do not have an accountant on staff yet, start a conversation with an accounting consultant to get the advice you need.