Every small business owner should know the difference between the two primary accounting methods: cash and accrual. Whether you plan to handle your own financial reporting or hire an outside professional, it’s essential to know how each one works so you can choose the best practice for your business.

Let’s discuss the differences and implications of each method.

The Cash-Basis Accounting Method

In cash-basis accounting, income is reported when it’s received, and an expense is reported when it’s paid. Many small business owners choose the cash method of accounting because it’s easy to track money as it moves in and out of your bank account. Additionally, your business doesn’t have to pay income tax on any revenue until the moment it’s deposited into your bank account. However, the cash basis can produce an inaccurate overall picture of your finances. Since it doesn’t account for all incoming revenue or outgoing expenses, it can show a positive cash flow even if that may not be the case. This is where the accrual basis can overshadow the cash basis.

 The Accrual-Basis Accounting Method

In accrual-basis accounting, income and expenses are recorded when earned, regardless of when they are actually received or paid. Inherently, taxes are paid in the current period in which income is earned. More businesses choose this method over the cash basis because it gives an accurate long-term picture of financial health. However, it is important to understand that accrual accounting may not provide a clear picture of current cash flow. Every business must keep a close eye on cash flow health to prevent the possibly devastating effects of an empty bank account.

 Click HERE to view our blog post for tips on creating a positive cash flow business.

Gaining Perspective

Which method is right for your business? Well, it depends. Let's walk through an example to help you understand the differences between cash and accrual-based accounting.

Let’s say you perform a service and invoice a client on December 1, 2023, but don’t receive payment until January 3, 2024.

Cash Basis:

Work was performed and invoiced in December 2023;

Income is reported when it is received in January 2024.

Accrual Basis:

Work was performed and invoiced in December 2023;

Income is reported when it is earned in December 2023.

As mentioned before, the accounting method you choose will have tax implications. The IRS requires certain businesses to use the accrual method (such as businesses with inventory or businesses with sales over $5 million/year). Once you begin your business and start paying taxes, the IRS requires businesses to report income using the same accounting basis continuously. In order to switch between accrual and cash-basis accounting for tax reporting, you must submit Form 3115.

Let’s take a look at how the taxes would be reported in the same example as above.

Cash Basis:

Work was performed and invoiced in December 2023;

Income is reported when it is received in January 2024.

Income taxes are reported and paid in the 2024 tax year.

Accrual-Basis:

Work was performed and invoiced in December 2023;

Income is reported when it is earned in December 2023.

Income taxes are reported and paid in the 2023 tax year.

Every business owner wants to reduce their tax burden. In most instances, the built-in control with the accrual basis allows for more flexibility on reported income. Continuing with the example above, if you determine that one year will see less income than another, then issuing the invoice during the lower income year will reduce your tax burden for the higher income year. Additionally, you may be able to request creditors to invoice you for the higher income year to reduce the tax burden on the higher income.

In cash-basis accounting, income control lies more in the hands of your customers. You may attempt to collect payments during the lower income year, but ultimately, the timing is outside your hands.

Alternatively, some businesses choose a hybrid-based accounting method by using the accrual method for inventory and the cash method for income and expenses.

Ultimately, it is up to the business owner to decide which method is appropriate for their business. If you’re still unsure which method is suitable for you, speak with a knowledgeable CPA, bookkeeper, and/or tax professional.

Schedule a time to chat with Wise Bookkeeper today for a free consultation to discuss your specific business needs at www.wisebookkeeper.com.