The way you do your business’s accounting may be second nature to you. You may have begun tracking your finances in a purposeful, informed manner, or you may have stumbled into an accounting method by default.
Whichever way you’re handling your business’s accounting, it’s likely you made a conscious or unconscious choice to use one of the two major methods: cash basis accounting or accrual accounting.
For smaller businesses, cash basis accounting does have several advantages over accrual methods.
Basic accounting: cash basis vs accrual
Cash basis accounting …
Cash basis accounting is really a matter of taking a snapshot of what’s on hand. If it’s not in your wallet, it doesn’t go on the books. Likewise, for expenses, if it hasn’t come out of your wallet, you’ve still got it.
If your small business is using cash basis method, here is how you would handle the following two transactions:
- You have hired a contractor to perform a service for you for a set, agreed-upon fee. With cash accounting, you won’t subtract the contractor’s fee from your books until he or she invoices you and you remit payment.
- One of your customers has signed a contract with you for a monthly retainer. Unless he or she has paid in advance, you can only account for what you’ve actually been paid.
The common element to each of the above examples is their immediacy; cash accounting lives in the present and is worried about true available funds.
Accrual Accounting …
In contrast, the accrual method of accounting is far broader-ranging than cash accounting.
If cash accounting is a snapshot, accrual accounting is a video taken over a period of time. Where the snapshot captures the details of a moment in time, the video tells what has been, what is, and projects what might be in the future.
Accrual accounting is far more focused on obligation. Once a business or financial commitment is made, whether that be a signed contract or a purchase put on credit, accrual accounting recognizes that that will be a legitimate change to your accounting books and needs to be treated as such immediately.
Examples of accounting methods
- EXPENSE. Your business required that you purchase some new equipment. Even though you bought that equipment with credit and will pay it off within the next year, you account for the entire cost of the equipment at the time you purchased it, because when you purchased it you became liable for that expense.
- INCOME. You’ve invoiced a client for a certain contract fee to be paid within a certain term. Though the funds have not yet been received, you will make a record of the fee as current income because it’s expected to come in.
Again, with cash accounting, it’s only when money changes hands that we do any record-keeping. So what happens to the pair of accrual basis examples change if they are handled with cash basis accounting?
Cash basis accounting for the same two examples:
- EXPENSE. Even though we purchased the equipment on credit, we record the payments, not the total amount, in our records.
- INCOME. Likewise, with the contract fee, we don’t count on that income until it has been deposited into our accounts.
When cash basis is not an option
Before we explain why cash basis accounting might be the best choice for your small business, there are a couple things we should mention. Things that could restrict your ability to choose cash basis over the accrual method.
Cash accounting is great for smaller businesses, but the IRS restricts the use of the cash method for some businesses. IRS Publication 538 summarizes this rule, saying, “Generally, if you produce, purchase, or sell merchandise, you must keep an inventory and use an accrual method for sales and purchases of merchandise.”
Please note that there are exceptions to this general rule depending on the type of business and amount of the business’s annual revenues. The IRS takes the accounting method very seriously! In fact, if you need to change your accounting method, you will need to complete IRS Form 3115. You can find more information about the rules for cash basis accounting on the IRS website, from your accountant, or in this related article:
The cash basis accounting advantage
So what are the pros of cash basis accounting?
- Cash accounting is relatively uncomplicated.
- It exists in the now and the present and deals only with concrete funds that go in and come out.
- Because of this simplicity, cash accounting is far easier to learn, implement, and maintain, and will be less costly for business owners to perform.
- There’s less to track, less to plan, and generally less to think about than with accrual accounting.
- There might be a tax advantage also. For example, you may have expenses in the current year (e.g., building materials), but not record the income until next year (i.e., the work is completed and payment received).
It’s as simple as that.
Our cash basis accounting table summarizes the pros and cons as described above. For smaller companies, whose operations are straightforward and generally predictable, the benefits of skipping the complication of projections, tracking, and forecasting (instead recording actual transactions) are massive.
Even the smallest of small businesses can consider using online cash basis accounting software to make their cash basis accounting efforts even simpler! Online cash basis accounting software can save non-accountant business owners a lot of precious time and money.
With smaller businesses, your operations can vary widely from moment to moment. Having an accurate and immediate picture of cash as it stands can provide some very necessary flexibility, in case of unexpected changes. Anything can change for a small business!
The last, final, and most crucial point is this: cash basis accounting is necessary for many small businesses. Because, operationally, those businesses are focused on the present — and their financial records should be focused in the present too.
Ready to do accounting for small business with the cash basis method? Try us for free today!