Accounting is the language of business, and there are two dialects and ways of speaking the language to your clients: Accrual Accounting and Cash Accounting.
According to the IRS, companies averaging a revenue of more than $25 million over the past three years are required to use accrual accounting. Certain corporations and tax shelters—including those that make sales on credit—also are prohibited from using cash accounting.
But if your client's business is small and their revenue is less than the IRS limit, they have the luxury of choosing the method of your liking. But to make the right choice, they need to understand the two ways and what each offers.
Here's everything you need to know about accrual and cash accounting so that your clients can see what best suits their small business.
Accrual Accounting
The accrual accounting method allows you to record revenue before receiving payment for goods or services sold. The technique also records expenses and debt as they are incurred.
In other words, using the accrual method means entering the revenue and expenses into your accounting journal regardless of when money exchanges hands.
Hence, the process allows the combination of present and future cash inflows and outflows, providing a complete picture of your company's finances.
Another thing to remember about the accrual method is that you'll need to pay tax on sales made in a given year, even if the money from those sales doesn't go into your account until the following year.
Cash Accounting
In cash accounting, you record payments only when they are received and record expenses when they get paid.
In other words, with the method, you only record transactions when money changes hands, and your actual profits will match what you register in your account.
Under cash accounting, contrary to the accrual method, you pay taxes only on the income you receive.
For example, if you send an invoice this tax year, the payment you'll receive next tax year, the income will not be taxable for the current year. Instead, it will be factored into your income for the following year.
An Illustration to Make Things Clearer
Suppose you make the following transactions in a month:
- You buy and pay for raw materials worth $1,000 this month.
- You send an invoice to one of your clients for $2,000 this month, which you'll receive next month.
- You cleared last month's bill of $200 this month.
- You received payment of $3,000 in response to last month's invoice.
Accrual Method
Using the accrual method, your monthly profit would be $1,000 ($2,000-$1,000).
And, you will need to pay income tax on $2,000 this month.
Cash Method
Using the cash method, your monthly profit would be $1800 ($3,000 - $1,000-$200).
And, you'll need to pay income tax on $3,000 this month.
Accrual & Cash Method – Advantages & Downsides
Now that you clearly understand the two methods, here are some advantages and downsides for you to consider.
Advantages of Accrual Accounting
This method provides a more accurate picture of the profitability of a company in the long term.
Investors and lenders particularly benefit from the accrual method as the consistency of critical metrics can make their business look more stable, increasing the chances of receiving funding.
For example, suppose a lender offering loans to consolidate debts uses this method. In that case, it will allow them to reflect their revenues and expenses during a given period, enabling them to achieve more accurate gross, operating, and profit margin analysis.
According to the IRS, companies averaging a revenue of more than $25 million over the past three years are required to use accrual accounting. Certain corporations and tax shelters—including those that make sales on credit—also are prohibited from using cash accounting.
Downsides of Accrual Accounting
It is a labor-intensive and time-consuming method. So, this option may not suit you if you have just started your business. But there are several online accounting software that you can use to ease the process.
Another downside of accrual accounting is that you have to pay taxes on revenue that you generate but haven't received yet.
Advantages of Cash Accounting
The key benefit of the cash method is its simplicity—it only accounts for cash paid or received.
Thus, the process makes it easier for small businesses to track their cash flow and doesn't require added staff (and related expenses) to use.
You also can benefit from using cash accounting when it comes to taxes.
Here is how: As you only record income and expenses when money changes hands, you can control the timing of transactions, speed up expenses and slow down revenue to lower your tax liability.
Downsides of Cash Accounting
The cash method can overstate the health of a company, and that's because the technique doesn't record the due amounts.
The unpaid amounts can exceed the cash on the books and your company's current revenue stream. As a result, you might conclude that your company is making a profit when, in reality, you're facing financial difficulties. You may think you have more money to spend than you have.
A clear picture of your long-term finances is essential to make informed decisions for your business growth. However, cash accounting fails in this regard.
Accrual Accounting & Cash Accounting (A Summary)
Accrual Accounting
- Records expenses and income as they occur.
- Profits and expenses may not match what is in your account.
- Taxes are levied on income that is pending.
- Required for larger enterprises that earn over $25 million in revenue and those with inventories, staff, and assets.
Cash Accounting
- Records expenses and income when it changes hands.
- Profits and expenses always match what is in your account.
- Taxes are not imposed on income that is pending.
- Only for small businesses and sole proprietors.
Accrual Accounting or Cash Accounting - Which One Is Right For You
Cash accounting is generally best for small businesses and businesses that do not carry inventory as part of their operations. On the other hand, large companies and inventory-based firms should opt for accrual basis accounting.
But if you expect your small business to grow, you should start with accrual accounting to stay prepared for future accounting needs.
Startups that usually take their first steps using the cash method eventually move to the accrual method when it comes time to apply for outside funding.
Suppose you get into a financial pickle and want to consolidate debts to pay your dues. Or, maybe your business is doing well, so you want to expand your business, and you need financing.
In both cases, a lender will want to know how much you owe, how well your customers pay you, and how current you are with your creditors. Following an accrual method will allow you to provide your lender with a complete picture of your financial situation, thus boosting your chances of getting a loan.
So, even if you do not follow the accrual standard now, you likely will have to in the future.
The Bottom Line
Many small businesses prefer to use cash accounting because it's the more straightforward and cheaper alternative, with the added benefit of not paying taxes on cash it hasn't collected.
But if you are looking to scale your business to new heights and attract outside investors, accrual accounting is your best bet.
Lyle Solomon has extensive legal experience as well as in-depth knowledge and experience in consumer finance and writing. He has been a member of the California State Bar since 2003.
He graduated from the University of the Pacific’s McGeorge School of Law in Sacramento, California, in 1998, and currently works for the Oak View Law Group in California as a Principal Attorney.
Like what you're reading?
Subscribe to our FREE newsletter and we'll deliver content like this directly to your inbox.