For tax purposes and to track your financial health, you’ll have to keep accurate and up-to-date financial records for your business. This typically done through one of two primary methods of accounting:cash basis accounting and accrual basis accounting.
With a few exceptions, the IRS requires businesses to choose a consistent method of accounting for each tax year. While you can switch from one to the other if needed, you must receive IRS approval to do so — so it’s best to choose the right one from the start and stick to it.
To help you decide which is best for your business, we defined and compared both methods.
What is cash basis accounting?
According to QuickBooks, cash basis accounting requires you to record income when you receive it and expenses when you pay them. Your profits will always match the amount that is in your account.
Pros
- Simple process; you record exact amounts available to you
- No requirement to pay taxes on money not yet received
Cons
- Misleading cash flow perception, as some earnings and payments shown are from a previous month
- No record of accounts payable and accounts receivable
- Only allowed for businesses that earn under $25 million in revenue
What is accrual basis accounting?
Accrual basis accounting requires you to record income as soon as it is earned and expenses as soon as they are billed. In this case, the amount in your account does not match your recorded profit.
Pros
- Accurate long-term view; you are calculating for future income and expenses
- Inclusive of businesses with revenue over $25 million
Cons
- Misleading short-term view; you have not yet received or paid the recorded income and expenses
- Requirement to pay taxes on money you haven’t yet received
[Read ouraccounting software guide on how to choose the best one for your business.]
Deciding how to record your financial data will impact many areas of your business, from taxes to cash flow projections.
Cash basis versus accrual basis: How to decide
When deciding which method to pursue for your business, you’ll want to consider the above advantages and disadvantages and how they impact your business. According to Bench, your two main considerations should be how you perceive your cash flow and how you are taxed. Here’s how each are affected by the two methods:
- Cash flow perception: With cash basis accounting, your cash flow perception might be off. It may look like you have positive cash flow one month, even though the work was completed in the previous month. On the other hand, with accrual basis accounting, you are recording both your credits and debts as soon as they are invoiced. Therefore, your cash flow perception is current and accurate.
- Taxes: As stated above, your profits, and how much you pay in taxes, can differ drastically depending on your accounting method. For instance, with accrual basis accounting, you’ll be taxed on your recorded profits even if you have not yet received them. With cash basis accounting, however, you’ll be taxed when you actually receive that income.
Hybrid accounting method
Depending on the type of business you run, you may not necessarily have to choose between cash and accrual basis accounting. Instead, you can use the hybrid accounting method, which combines aspects of both methods so you can both track your cash flow and see a long-term view of your finances.
There are special IRS rules for the hybrid method, and certain businesses — small mining operations, manufacturers, wholesalers and retailers — are required to use it. More information is available in IRS Publication 538.
[For more, see: What is Financial Accounting?]
How to choose the right accounting method for your business
Deciding how to record your financial data will impact many areas of your business, from taxes to cash flow projections. You may want to consult with a financial professional to help you choose between cash and accrual basis accounting, or to determine if a hybrid method is right for you.
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