Many small business owners possess basic knowledge at best when it comes to accounting. They are generally familiar with basic accounting terms, and they only keep tabs on the most important financial metrics, like cash flow and profitability. What these business owners don’t give much attention to, however, is the accounting method they use. Little do they know that their accounting method plays an integral role in their business’s financial health.
Your business’s accounting method determines the way you file tax returns, along with the format of your financial statements. Have you ever scanned your financial statements for a very important piece of data, only to realize that it’s nowhere to be found? The absence of this data is likely attributed to the accounting method that was chosen by your accountant or bookkeeper. But that doesn’t necessarily mean the wrong method was chosen.
There are two main accounting methods for small businesses: cash basis and accrual basis. At the very least, all small business owners should know the primary differences between the two, the kind of businesses associated with each method, and why your chosen method makes sense for your business’s circumstances.
For example, one major factor in this decision is your business’s tax obligations. Choosing the wrong method for your tax obligations could put your entire operation in jeopardy.
In this guide, we’ll go over the pros and cons of each accounting method and explain why understanding your chosen method can help you make better financial decisions.
Accounting for Small Businesses: Two Methods
With cash basis accounting, the business records revenue on financial statements when it receives cash, and records expenses when it spends cash or accrues debt. With accrual basis accounting, the business records revenue along with the expenses used to generate that revenue at the same time.
Legally speaking, any type of business can technically use accrual basis accounting. But in order to use cash basis accounting when reporting to the IRS, the business must have earned less than $25 million in gross revenue over the past three years.
Why Your Small Business Accounting Method Matters
The two areas of your businesses that are most impacted by your accounting method are bookkeeping and tax filing. Your accounting method determines the income and expenses that are reported on monthly financial statements. Since each method has its own way of portraying financial transactions, your method determines the tax year that those transactions fall under as well.
According to the IRS, small businesses must choose from four accepted accounting methods: cash basis, accrual basis, a mix of the two, or a fourth, highly specific method that offers special categories for certain types of income and expenses.
When the time comes to file your business’s taxes, the IRS requires businesses to use a standardized and consistent accounting method each year. So, if you want to use a different accounting method than you used last year, you must obtain approval from the IRS. If you don’t get IRS approval for using a new method, the IRS will not accept your tax return and you may have to pay a fine for underpaying taxes.
The US Securities and Exchange Commission (SEC) and the Financial Accounting Standards Board require all publically traded companies to use accrual basis accounting. Small, private companies can use whichever of the aforementioned four methods they want.
What’s the point of all these rules?
The IRS is merely trying to enforce consistent record keeping so it has an easier time handling business taxes. Requiring approval for new methods also encourages businesses to choose the right method from the get-go. Lastly, businesses are simply more likely to succeed when they use the right method for their circumstances. They get a clearer picture of their financial health, which ultimately prevents them from unknowingly sabotaging themselves with poor decisions.
The Two Most Common Accounting Methods for Small Business
Businesses that use accounting software should have already encountered cash basis and accrual basis accounting. Most accounting software programs ask you to choose between the two methods when setting up your bookkeeping system.
While cash basis is by far the most commonly used method, both methods have pros and cons. Let’s delve into those and clarify why cash basis is so popular:
Accounting Methods: Cash Basis Accounting
The majority of US small businesses use cash basis accounting when keeping financial records and filing tax returns. With cash basis accounting, income is recorded when it’s officially in your bank account.
For example, let’s say you completed a project for a client on June 15. Afterwards, you sent that client an invoice with a due date of July 3. Even though you did the work and billed the client in June, you won’t record the income until you actually receive it in July. The income will therefore appear on your financial statement for July, not June.
Cash basis accounting also records expenses once they are paid, as opposed to when you receive the bill or when the payment is due. Let’s say you forgot to pay a recurring bill that was due by the end of August. At the end of September, you’ll probably receive a statement asking for August’s bill as well as September’s. So, even though the bill was due in August, cash basis accounting says the expense should show up on your financial statement for September.
Pros of Cash Basis Accounting
As you can see, cash basis accounting is the most logical approach. You don’t have to own a business to know that it makes more sense to record income when you receive it and expenses when you pay them. Cash basis accounting is so easy that you might not even need to hire a bookkeeper or accountant.
Also, cash basis accounting saves you from having to enter invoices you send and bills you receive into your books. Remember, you only record data when you receive or spend money. You don’t have to record invoices or bills because none of these actions (receiving or spending) took place. The exact date in which you sent an invoice or received a bill doesn’t really matter. Cash basis accounting software automatically records when money is received or spent. You don’t have to manually enter any information.
And since cash basis accounting revolves around receiving and spending, it provides a very clear picture of your business’s cash flow. Anytime your bank account goes up or down, whether it’s from a bank transfer or check transaction, cash basis accounting records it.
Cons of Cash Basis Accounting
The recording method of cash basis accounting can be misleading when it comes to your business’s output. Customers of service-based businesses often pay services several weeks (or months) after the service was performed. But in the previous section, we established that cash basis accounting does not record the sending or receiving of invoices.
When reviewing your financial statements, you wouldn’t be able to tell when you did the actual work for a customer. You’d only be able to see when you got paid. In other words, what seems like a busy month (due to the income you received) could actually be a slower month in terms of output. And what seems like a slow month (due to the lack of income) could really be when you did the most work that season.
This misleading data could cause you to make dangerous decisions, like unknowingly booking a vacation or cutting crucial expenses for a very busy month.
Cash basis accounting also makes it difficult to track monthly profitability. Let’s go back to our hypothetical scenario in which you forgot to pay a recurring bill. With cash basis accounting, your financial statements wouldn’t show you when that bill was due. What they would show you, however, is a higher profit for that month.
In the other example, we envisioned the scenario of completing a project during one month but not getting paid until the next. With cash basis accounting, your financial statements would show erratic profits month-to-month, even though you have a solid sales cycle. It’s just harder to see the connection between performing a service and getting paid for it.
Accrual Basis Accounting Method
Though most small businesses can use whichever accounting method they want, accrual basis accounting usually makes more sense for larger businesses. With accrual basis accounting, income is recorded when it’s earned, not received. And by “earned,” we mean a sale or deal taking place. Let’s say you are tasked with a project in June but don’t get paid until July. The income would still show up on June’s financial statements. It was during this month that the initial sale took place, even though you did not receive any income up front.
Accrual basis accounting also records expenses when they’re incurred, as opposed to when you actually pay them. So, even if you forget to pay a recurring bill that’s due in August, the bill would still show up on your financial statements for that month.
Pros of Accrual Basis Accounting
Compared to cash basis, accrual basis accounting makes it much easier to accurately track monthly profitability. Your financial statements would clearly show you the months in which you incurred the most/least expenses, as well as when you performed the most/least sales. This allows you to make better decisions leading into these months the following year. For example, since you can see which month involved the most sales, you could plan to hire more workers in anticipation for the upcoming surge in demand.
The ability to accurately track profitability also makes accrual basis accounting the preferred method for business lenders and equity investors. Profitability is one of the first things people look at when deciding whether to approve business funding or buy ownership. If you plan on seeking funding from a traditional institution, you may want to consider switching to accrual basis accounting so you can present financial statements in this format.
Cons of Accrual Basis Accounting
While profitability is easier to track, we can’t say the same about cash flow. Accrual basis accounting does not record when money actually enters or leaves your bank account. The owner of any service-based business will tell you that making lots of sales doesn’t always mean you’re making lots of money at the same time. Your profit and loss statement could show an increase in profitability during a busy month even though your bank account is dangerously low.
So, if you use accrual basis accounting, you cannot rely on your profit and loss statement alone to assess your financial health. Instead, you must review this statement alongside your cash flow statement. Without your cash flow statement, you won’t be able to see the time frame between making sales and getting paid for them.
Earlier, we mentioned that cash basis accounting does not require you to enter invoices and bills into your books. With accrual basis accounting, on the other hand, you must record both before producing financial statements. If you don’t constantly update your books throughout the month, the end of the month could become incredibly stressful. This is a big reason why accrual basis accounting is commonly associated with larger businesses. Unlike most small businesses, bookkeeping and financial statements for larger businesses are handled by a team of professionals. Thus, small businesses should probably avoid accrual basis accounting unless they have the resources to hire bookkeepers and accountants.
And since accrual basis accounting records income when it’s earned, you may also end up paying taxes for money that has yet to reach your bank account. Businesses that use accrual basis accounting tend to pay higher taxes in general.
Which Businesses Should Use Cash Basis Accounting?
Small business owners love simplicity because it’s so rare in their careers. Cash basis accounting is much less complicated than accrual basis accounting, which makes it the logical choice for the average entrepreneur. Here are a few common situations that could steer you towards cash basis accounting:
1. You’re a new business owner
New entrepreneurs tend to favor cash basis accounting solely because it requires less effort and knowledge. With so many responsibilities on their hands, new entrepreneurs often don’t have the time to learn how to update their books in the style of accrual basis accounting.
New entrepreneurs also might not have the resources to hire a bookkeeper or business accountant. Have no fear: even the least financially-savvy entrepreneurs can handle cash basis accounting entirely on their own.
2. You’re trying to pay as little taxes as possible
We previously noted that accrual basis accounting can lead to paying higher taxes. Well, that’s the last thing a new entrepreneur wants to do, especially if revenue hasn’t taken off just yet. Luckily, cash basis accounting shows you exactly how much cash you have in your bank account at any time.
Let’s say you performed a service before the deadline for filing tax returns, but the client paid you after the deadline. With cash basis accounting, you wouldn’t have to report the sale for the previous year’s taxes because the income didn’t hit your bank account. Instead, you’d report the revenue and pay taxes on it for the new year.
Which Businesses Should Use Use Accrual Accounting?
Despite the popularity of cash basis accounting, it would still make more sense for certain businesses to use accrual basis accounting. Here’s a few of those scenarios:
1. Your average gross revenue over a three year period exceeds $25 million
Any business that averages more than $25 million in gross receipts must use accrual basis accounting when filing tax returns. Up until 2019, the threshold for using accrual basis accounting was $5 million. That ended with the passage of the Tax Cuts and Jobs Act, a.k.a. the Trump Tax Plan.
2. You sell inventory
Another provision of the Tax Cuts and Jobs Act affects businesses that sell inventory. Prior to the law, any business that sold inventory had to use accrual basis accounting. Today, businesses that have earned up to $25 million in revenue over the past three tax years can either categorize their inventory as “non-incidental materials” or use the same accounting method from their previous financial statements.
3. Your state’s sales tax laws require it
Certain states require businesses to use accrual basis accounting when filing sales tax returns. Businesses located in these states must therefore take extra measures to ensure timely payments after sending invoices. Failing to do so could essentially result in paying sales taxes on money they haven’t received. Examples of such measures include an automated invoicing system or accounts receivable/invoice factoring.
Small Business Accounting Methods: More Options
Cash basis and accrual basis are easily the most popular accounting methods. But many small businesses have no legal requirement to use either option. Deviating from these two, however, creates significantly more work for the business owner (and their accountant).
With the Percentage of Completion method, the reported cost of a project depends on the expenses involved and the revenue it brings in. The Completed Contract method accounting postpones the reporting of expenses and income until the project is complete.
Lastly, High-Low accounting factors in fluctuations in the business’s total operating cost during fluctuations in the business’s output or productivity.
It’s also possible to use two different accounting methods for different purposes. For example, you could use one method for producing financial statements and another for filing tax returns.
Choosing the Right Method for Your Small Business
You may have noticed that invoices are a recurring theme throughout this guide. This is because invoice-centric businesses likely have the toughest choice when it comes to accounting methods. At first, accrual basis seems like the logical choice because customers often pay later than the requested due date. Then again, there are plenty of ways to shorten these gaps in cash flow. In summary, the amount of time it usually takes for customers to pay you should dramatically impact your decision.
If you’re not sure which one makes the most sense for your business, there’s no harm in experimenting with both. Like any other important business decision, you might as well do whatever you can to achieve absolute certainty.