Should your small business adopt a cash or accrual accounting method? This article will explain what exactly these are, their differences, and give you advice on which accounting to use.

 

An accounting method is simply how your business chooses to track income and expenses. They only differ in the timing. The two options for your small business are cash method or accrual method (sometimes called cash basis or accrual basis accounting). 

 

Cash Method

Using the cash method, you will record income at the time you actually have the cash (or check) in hand or you actually have paid a bill. This is by far the more common form used by small business and that is because it is simpler. Think about it, in your personal life you record your income on a cash basis. This year you will only pay taxes on money you have actually received, not money you earned those last two weeks of the year but haven't gotten paid for yet. Cash in hand = you account for it. 

 

Accrual Method

Accrual method is the opposite of the cash method. Under the accrual method, income and expenses are counted when they are incurred. You will enter the transaction on your books when someone signs the contract, you finish the work, or whenever you become obligated to pay someone whether the money changes hands at that moment or not. Accrual users should pay close attention to cash flows because your books can show many sales coming in but your bank account could be empty because the cash has not come in yet.

Examples:

  • Your home cleaning business does work in the month of December, and you bill the client on December 31st. You actually receive the cash on January 15th. For cash method, you would record the money on your January books. For accrual method, you would record the income in December as that is when it was earned. 
  • The same goes for your expenses. You hire an IT professional to work on your website and the work is done in March. You pay 2 payments of $500, one in April and one in May. For cash method, you would record a $500 expense on your books for April and a $500 expense for May. For accrual method, you would record all $1,000 on your March books because that is when you became obligated to pay it.

 

Most small businesses (under $5 million in revenue) are free to choose either method. If you are not comfortable with accrual based accounting, you should stick with the cash method. Cash is simple, straight forward, and you don't have to worry about cash flow problems. If you have over $5 million in revenue, you should consult with a CPA to make sure you are in compliance with the law.