As you set up your new business, one of the decisions you’ll need to make is whether to use the cash or the accrual method of accounting when creating your financial statements and filing your taxes. 

Today, we’ll explain the difference between the two, the pros and cons of each, and how to decide which accounting method is best for your small business.

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What is cash-based accounting?
What is accrual-based accounting?
Example of how a month of income might look using cash vs. accrual-based accounting
How does each method affect taxes?
How do you choose which method is best for you??

What is cash-based accounting?

Businesses that use a cash-based accounting system recognize revenue when it hits the bank, rather than when an invoice is sent. This accounting method is popular with small businesses because it’s easy to maintain and fairly straightforward – either you have money in the bank or you don’t.

Operating on a cash basis means that existing balances in accounts receivable or accounts payable will not be included in your revenue amount, until those balances are paid.

Using this method means that since you operate your business based on the money you actually received, you’ll also pay taxes on the amount you received, rather than the amount you invoiced.

What is accrual-based accounting?

Businesses that use an accrual-based accounting system recognize revenue when it is earned, whether or not that money has already been received. Because this method gives businesses a more realistic picture of their income and expenses for a given time period, accrual-based accounting is more commonly used than cash-based accounting.

However, accrual-based accounting doesn’t take cash flow into consideration, meaning a business can appear profitable while having no money in the bank. If you choose to use this method, be very careful about monitoring your account balance or risk frequent overdraft fees.

Here’s an example of how a month of income might look using cash vs. accrual-based accounting

May 2017 Transactions:

1. Invoiced $4,000 for an ad campaign you designed this month
2. Received $2,500 from a client whom you invoiced in last month
3. Paid $200 in bills from last month
4. Received a bill for $700 for a referral fee this month

May’s profit using cash-based accounting: $2,300 ($2,500 in income minus $200 from bills) May’s profit using accrual-based accounting: $3,300 ($4,000 in income minus $700 in referral fees)

How does each method affect taxes?

One of the biggest differences between the two accounting methods is how you report your income to the IRS at tax time. If the above example had taken place in December 2016, the accounting method you use will affect how you report that income on your tax return.

For example, using the accrual method, you would report that $4,000 invoice on your 2016 tax return (and pay taxes on it), even if you didn’t actually receive the money until January.

However, if you use the cash accounting method, you wouldn’t report that $4,000 income until you actually received it, meaning if you received it in January, you would wait to pay taxes on it until the following tax season.

Another way your chosen method of accounting affects taxes is in how you claim deductions for a given tax year. For example, if you operate on a cash basis and incurred a business expense in December 2016 but didn’t actually pay it until 2017, you wouldn’t be able to claim it as a business expense on your 2016 tax return. However, if you operate on an accrual basis, you would be able to claim it as a business expense for 2016 because you record transactions as they occur, not when the money actually moves in and out of your accounts.

How do you choose which method is best for you?

You’ll choose whether to operate on a cash or accrual basis the first time you file taxes for your business. As a small business owner, you can choose to use either type of accounting method, as long as your sales total less than $5 million each year. However, businesses that make more than $5 million a year or keep an inventory of merchandise to sell to consumers are required by law to use the accrual method, so check with your accountant if you need help deciding which method is best for you.

Remember that the cash method helps you keep better track of how much money you actually have at any given moment, and the accrual method gives you more of an accurate view of your business transactions. Some businesses even choose to use a hybrid method where they use accrual accounting for inventory and cash accounting for income and expenses.

Once you choose an accounting method, you’ll need to continue filing your taxes using that method so you don’t run the risk of an audit. If you ever need to change accounting methods, file Form 3115 to ask for approval from the IRS.

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