As a small business owner, there are many decisions to be made, particularly when you’re just starting out, to ensure everything runs smoothly and efficiently. One important decision to make is selecting an appropriate accounting method for your business. Accounting methods are simply the rules your business will follow when reporting revenues and expenses. Today, we’ll dive into the two primary accounting methods — accrual vs cash-based accounting — what they mean, and how to choose between the two when setting up your business.
Before we get started, it’s important to note the IRS requires taxpayers to choose an accounting method that accurately reflects their income and to be consistent with their choice of accounting method from year to year. This is because switching between methods could potentially allow a company to manipulate its revenue to minimize its tax burdens. To change your accounting method, you must receive approval from the IRS, typically with Form 3115. It’s important to choose your method carefully; if you’re unsure which method would work best for you, consult with a tax advisor before launching your business.
Cash-Based Accounting Method
We will start with the cash-based accounting method, as it is the method most used by many small businesses. Cash-based accounting recognizes revenue when cash is received and when expenses are paid. For example, when you receive a bill from a vendor that is due next month, that expense is not recognized until it is paid. This is a simpler method because there is no need for accounts like Accounts Receivable or Accounts Payable – only cash accounts are required. This option is great for freelancers and sole proprietors just starting out, as reporting needs are generally fewer than those of large corporations.
Though this option is the method of choice for many small business owners, one of its biggest disadvantages is that it doesn’t show the full picture of your business. Cash-based accounting does not show your business’s liabilities, and as a result, you may think you have more money to spend than you actually have.
Generally, business owners are free to choose the method that works best for them and their business needs. However, some businesses may not have a choice when it comes to selecting an accounting method and are required to use the accrual method based on several factors, which we will discuss below.
Accrual Accounting Method
The accrual method of accounting is more complex than the cash-based method, however, it offers a more accurate picture of a company’s assets and liabilities on its balance sheet. When using the accrual accounting method, a company recognizes revenue during the period it is earned and recognizes expenses when they are incurred. This is often before, or sometimes after, it receives or dispenses money. Accrual accounting uses asset and liability accounts – Accounts Receivable and Payable – to reflect revenues a company has earned but hasn’t yet been paid for and amounts a business owes but hasn’t yet paid, respectively.
The accrual method is the only method allowed under GAAP (General Accepted Accounting Principles) and is required by the SEC (Securities and Exchange Commission) for publicly traded companies. Therefore, companies that are publicly traded are required to use the accrual method of accounting. In addition, this method must be used if a business is worth more than $26 million or if they have average annual gross receipts of $26 million for the prior three years.
Though this method offers more detailed insights into a company’s finances, it is more complicated and requires more time and resources than some small business owners have available. It can also skew the short-term financial view of a company. For example, if you invoice $5,000 in a month, the accrual method will show that you earned that money even if you received none, making it appear like you have more money than you do.
Special Rules and Considerations
There are special rules when it comes to businesses with inventory and businesses that fall into certain categories. If you purchase inventory or goods to resell or need assistance choosing which accounting method would work best for your business, talk with your accountant to learn more about your options.