As a business owner, you have to make important decisions daily. One thing you need to decide when you start your business is an accounting method. Methods you can choose from include cash-basis, modified cash-basis, and accrual accounting.
The two methods that differ the most are cash-basis and accrual accounting. To help determine which method is best for your business, weigh the pros and cons of accrual vs. cash-basis accounting. And, review accounting laws to ensure you stay compliant.
Accrual vs. cash-basis accounting
What is the difference between cash and accrual accounting? Compare and contrast the two methods below.
Cash-basis accounting is the simplest accounting method. Because it’s the easiest method to understand and use, many small businesses tend to use it for bookkeeping.
The cash accounting method only lets you use cash accounts. You can record things like cash, expenses, and income with cash-basis accounting. However, you can’t track long-term liabilities, loans, or inventory.
With cash-basis, you record income when you receive it. You only report expenses when you pay them.
Some advantages of cash-basis accounting include:
- Less expensive than other methods
- Ideal for small business owners
- Simple and easy to use
- Less information to track
- Easier to maintain
Like with anything in business, cash-basis has some cons as well, including:
- Fewer available accounts (e.g., can’t track long-term items)
- Fewer businesses that can use it as they grow
- More restrictions on which businesses can use it
Your balance sheet for cash-basis accounting includes three parts: your assets, liabilities, and equity. Do not record accounts payable, accounts receivable, or inventory on your balance sheet. This means your balance sheet does not show unpaid invoices and expenses.
Here is a cash-basis accounting balance sheet example:
Accrual accounting is the most complex option out of all the accounting methods. To use accrual-based accounting, you typically must have some basic accounting knowledge.
With accrual accounting, you use more advanced accounts, such as accounts payable, current assets, long term liabilities, and inventory.
Record income when your transaction takes place, with or without the transfer of money. And, you must record expenses when you’re billed with accrual accounting.
A few advantages to using accrual accounting include:
- Anticipating future income and expenses
- Projecting and viewing long-term profitability
- Helping you make smart financial plans
- Accessing many types of accounts for transactions
Although there are many benefits to using accrual accounting, there are also some cons. A few disadvantages include:
- Being more complex than other accounting methods
- Needing more accounting knowledge to use it
If you use the accrual method, your balance sheet will have more details and list additional accounts. Below is an example of an accrual business balance sheet.
Comparing cash basis vs. accrual-basis accounts
Since accrual accounting is more complex than cash-basis, it uses many more types of accounts. Take a look at the following chart to review different accounts you can use with cash-basis and accrual accounting.
Modified cash-basis accounting
Modified cash-basis, or hybrid accounting, is a blend between cash-basis and accrual accounting. This method is ideal for businesses needing to record and balance both short- and long-term transactions.
Modified cash-basis uses accounts from both accrual and cash-basis, such as cash, current assets, accounts payable and long-term liabilities accounts.
With modified cash-basis, you can record short-term items like cash-basis accounting. However, you can also include long-term items like you can with accrual.
Accounting method laws
Most businesses can choose whichever accounting method they would like. However, there are some rules restricting certain businesses from using different methods.
The IRS sets rules for which businesses can record transactions using cash-basis accounting. Larger businesses cannot use cash-basis.
You cannot use cash-basis accounting if:
- Your annual gross sales are more than $5 million
- Your business’s gross receipts for inventory sales are more than $1 million
Examples of cash accounting vs. accrual
Check out a couple of examples below of recording income and expenses using the different accounting methods. Before peeking at the answers, test your knowledge on accrual and cash-basis accounting.
1. Julia orders some supplies for her business. She uses the cash-basis method. When does she record the expense in her accounting books?
A. When the supplies are delivered
B. Before the supplies are delivered
C. When she pays for the supplies
2. Say Julia is using the accrual accounting method instead of cash-basis. When would she record the supplies?
A. Before the supplies are delivered
B. When the supplies are delivered
C. When she pays for the supplies
Answers: 1. C and 2. B
1. John owns a marketing agency. He completed a project for a customer and is ready to be paid. At what point does he record his income with cash-basis accounting?
A. When the client pays the invoice
B. As soon as he completes the project and sends the invoice
C. Right after he finishes the project, but before invoicing the client
2. John finishes a project for another client. Let’s say he’s using the accrual method. When will John record his income with the accrual accounting method?
A. When the client pays the invoice
B. Right after he finishes the project, but before invoicing the client
C. As soon as he completes the project and sends the invoice
Answers: 1. A and 2. C
Changing from cash-basis to accrual
As some small businesses grow, they find they need to upgrade their accounting method. If you need to change from cash-basis to accrual, you must follow a few steps.
Adjust your business books to reflect the shift. When switching from cash-basis to accrual, complete the following steps:
- Add prepaid and accrued expenses
- Add accounts receivable
- Subtract cash payments, customer prepayments, and cash receipts
After you adjust your books, fill out and file Form 3115, Application for Change in Accounting Method, with the IRS. Form 3115 allows you to request a change in your accounting method.
The earlier you file the form, the better. Attach your profit and loss statement, balance sheets, and any adjustments from the previous year to Form 3115.
Choosing an accounting method
When it comes down to selecting an accounting method that is a good fit for your small business, consider a few factors first.
Think about things like:
- Accounting laws you must follow
- How big your business is
- How much your business will grow over time
- Future accounting needs
- Types of transactions you need to record
- Which types of accounts you need (e.g., long-term liabilities)
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This article has been updated from its original publication date of July 29, 2013.
This is not intended as legal advice; for more information, please click here.