Cash Versus Accrual Accounting: Which to Use?
Unless you actually run an accountancy or bookkeeping business, accounting isn’t usually at the top of a business owner’s mind. But if you don’t understand your books, you don’t understand your business, and the choice between cash and accrual accounting is a choice about how you choose to view your business, so it’s an important difference to know about (and make an informed decision on).
Cash Accounting
This is the type of accounting that is used by many small businesses and for personal finance. It is called “cash” but obviously deals with whatever forms of payment you take. You enter revenues when you receive revenues and you enter expenses when you pay expenses.
Pros
- The process is simpler and easier, both for you and for your accountant
- You get an excellent short-term, day-to-day glance at your business
- Your bank balance bears resemblance to your bookkeeping
Cons
- You cannot make long-term decisions based on this type of accounting
- These books can sometimes provide an inaccurate picture of the company
- E.g. you could have a very large amount of cash on hand but have payables that exceed all of that amount and then some
Accrual Accounting
This is the opposite of cash accounting. You book revenues when you have an agreement in place (even if you have not been paid) and you book expenses when they are incurred (not when you have paid them).
Examples:
- A client signs up for one of your products and services in March, but they will take delivery in April, hence they may not pay you until then or later. But in accrual accounting you book that revenue in March, not April.
- A vendor sends you an invoice in June. It is due in July. In accrual accounting you book the expense in June.
Pros
- This is the type of accounting that investors want to see because it gives a better sense of the long-term performance of the company
- It’s more accurate (and GAAP recommended), because you have a better view of the profitability of the company over an entire year
Cons
- Because you have to record revenue before actually receiving it, cash flow is tracked separately
- This type of accounting is significantly more expensive in time and money
- You don’t have a short-term picture of your business
The Choice
Many businesses can choose which type of accounting to use, but some can’t.
- If you stock items to sell to the public and do more than $1M/year in revenue, you have to use accrual accounting
- If you do more than $25M/year in revenue, the IRS requires you to use accrual accounting
If you do want to switch over from cash to accrual you can’t just decide to do it, you have to ask permission of the IRS via Form 3115, and if they approve you, you have to stick to that choice for the whole year. No changing mid-stream.
Small businesses without a lot of cash on hand and are primarily B2C will often choose cash accounting, simply for the ease of it. Businesses that keep a large inventory or don’t get paid quickly will often choose accrual accounting, simply because it makes more sense.
This is ultimately a decision you should make with the advice (and consent?) of your accountant. He/she knows your business, knows its cash flows, but most importantly, knows you, how you deal with different financial statements, and what your long term goals with the business are. Armed with that information, it’s easy to figure out whether your business should be using cash or accrual accounting.
If you want us to take a look at your books to see whether you’re in a good position to sell, we’re always happy to not just look, but offer suggestions on what you can improve and clean up to get ready for a future sale. Give us a call today.
