24 Jul Accrual or Cash Accounting for Small Business: What’s Best?
As a small business owner, you make important decisions every day. Some of these decisions are more obvious and easy than others. But sometimes, the stakes are higher and the decisions are tougher. That’s often the case when it comes to accrual or cash accounting for small businesses and deciding what’s best.
If you’re stuck in that same boat, we’re here to help. Today we’re going to discuss choosing between accrual or cash accounting.
But first, let’s define each of these terms.
What is accrual accounting?
Let’s go right to Investopedia to define accrual accounting:
Accrual accounting measures the performance and position of a company by recognizing economic events regardless of when cash transactions occur.
Essentially, the income or expense is recorded when the transaction occurs, rather than when an actual payment is made or received. While this method provides a more clear picture and better insights into a business’ condition, it’s also more complex than cash accounting.
What is cash accounting?
Now, cash accounting, on the other hand, only recognizes economic events when an exchange of cash occurs.
Accrual vs. cash accounting in action
Let’s look at accrual accounting vs. cash accounting in action to get an even better idea of how they work.
Your marketing company provides a $10,000 service to one of your clients on July 30. Your client gets the bill and pays it on August 15.
Under the accrual method, this revenue is recognized as being earned on July 30, even though you hadn’t received payment yet.
With cash accounting, you’ll record that revenue on August 15, the day you actually received payment.
Accrual or cash accounting and taxes
Another key difference between these types of accounting is when it comes time to file your taxes.
With cash accounting, you don’t pay taxes on money that hasn’t been received yet. Accrual accounting, on the other hand, means you pay taxes on the money you’re owed but have yet to receive.
Accrual or cash accounting for small businesses
Choosing between accrual or cash accounting will often come down to the size of your business.
Many small businesses prefer to use cash accounting simply because it’s easier to maintain and understand. Although accrual accounting doesn’t provide an accurate depiction of cash flow, it DOES give you a more realistic idea of long-term income and expenses.
So, how do you know if accrual or cash accounting is right for your small business?
Let’s hear what the IRS has to say:
The following entities cannot use the cash method, including any combination of methods that includes the cash method.
- A corporation (other than an S corporation) with average annual gross receipts for the 3 preceding tax years exceeding $25 million (indexed for inflation). See Gross receipts test, below.
- A partnership with a corporation (other than an S corporation) as a partner, with average annual gross receipts for the 3 preceding tax years exceeding $25 million (indexed for inflation). See Gross receipts test, below.
- A tax shelter, as defined in section 448(d)(3).
So, if your small business is a corporation (other than an S corp) that averages less than $25 million in gross receipts each year, cash accounting is an option for you.
That being said, the cash method is usually more suited for small businesses that don’t carry inventory. If you’re an inventory-based business, accountants tend to recommend accrual accounting.
Do I need to change my accounting method?
If you’ve just realized you need to switch accounting methods or that you’ll soon need to, the next important question to ask is about changing your accounting method.
Can you go ahead and switch from cash to accrual accounting?
According to the IRS, the following changes in accounting method require their approval:
- A change from the cash method to an accrual method or vice versa.
- Change in the method or basis used to value inventory.
- A change in the depreciation or amortization method (except for certain permitted changes to the straight-line method).
While we’re discussing finances for small businesses, be sure to check out these four unusual financial strategies for small business owners.
A clear picture of your finances
What if your small business hasn’t been keeping up with bookkeeping and you’re not really sure where you stand?
If you’re stuck choosing between accrual or cash accounting, we can help! Up-to-date, accurate bookkeeping is a must, and this is a service we’re proud to offer. Once you have a clear picture of your finances, you’ll know exactly where you stand. Empowered with this information, you can make the smartest decisions for the future of your business.
Whether your small business uses accrual or cash accounting, we can make sure your books are impressively current, accurate, and clear.
If any of the above sounds too good to be true, don’t leave it there. Schedule a quick call and we’ll get you a price. It truly is that simple.
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