Choosing your accounting method is the first step in handling your company’s books. If you’re a small business owner, you may prefer the simplicity of cash basis as opposed to accrual or modified cash-basis accounting. But before solidifying your decision, learn the pros and cons of cash-basis accounting.
A little bit about the 3 accounting methods
The two main accounting methods are accrual and cash basis. But, there is also a third method, known as modified cash-basis or hybrid accounting, that uses aspects of both.
What are they? What’s the difference between them?
Cash-basis accounting is the simplest accounting method available. In cash-basis accounting, you record income when you physically receive it and expenses when you physically pay it. You only use cash accounts, meaning you do not deal with accounts like Accounts Receivable, Accounts Payable, or any long-term liability accounts. Cash basis uses single-entry bookkeeping.
Accrual accounting, on the other hand, is a more complex accounting method. In accrual accounting, you record income and expenses whenever a transaction takes place, even if you don’t physically receive or pay. You use more advanced accounts, like Accounts Receivable and Payable. You can also track long-term liabilities. Accrual uses double-entry bookkeeping.
Modified cash-basis accounting is a hybrid between accrual and cash-basis accounting. It has more accounts than the cash-basis method because it uses the accounts used in accrual. However, you only record income and expenses when money is received and paid, like in cash-basis accounting. Modified cash-basis accounting uses double-entry bookkeeping.
To sum it up: Cash-basis accounting is a snapshot of your business’s transactions and only focuses on payments that have actually happened. Accrual accounting is an in-depth look at your business’s transactions and also focuses on obligations.
Pros and cons of cash-basis accounting
If you are thinking about adopting the cash-basis method, you should get to know its pros and cons. Learn more below.
Advantages of cash-basis accounting
For smaller businesses, cash-basis accounting has a number of advantages over accrual or modified cash basis.
1. Easy to use
Because cash basis is the easiest accounting method, it’s much easier to learn, implement, and maintain for business owners. Not to mention, it might be more cost-efficient, too.
The learning curve for cash-basis accounting is significantly lower than for accrual accounting. There are fewer accounts to keep track of, and therefore less information to track.
You don’t have to plan as much or go into specifics with cash accounting. That means more time for your business and less time engrossed in the nitty-gritty details of accounting.
2. Exists in the present
Another advantage of cash-basis accounting is that it lets you easily see how much cash you actually have on hand.
Cash-basis accounting only deals with concrete funds that go in and come out, meaning it exists in the now. You don’t have to factor in future expenses and income into your books until cash actually changes hands.
3. Potential tax advantage
Some businesses may benefit from using cash accounting when it comes to taxes. Because you only record income and expenses when money actually changes hands, you can control the timing of transactions.
By controlling transaction timing, you can speed up expenses and slow down revenue. That way, you can legally increase your expenses and decrease income to lower your tax liability.
Disadvantages of cash-basis accounting
Despite its benefits, there are some cons to using cash-basis accounting. Consider the following before deciding on the cash-basis method.
1. Doesn’t show the full picture
One disadvantage of cash-basis accounting is that it gives your business a limited look at your income and expenses.
Cash basis does not show your business’s liabilities. As a result, you may think you have more money to spend than you actually have. Likewise, it doesn’t show your customer’s liabilities to your business, which could cause you to forget about unpaid customer debts.
Because cash basis is just a snapshot of your business’s finances, you may not have a clear picture of your long-term finances. This could impact decision-making as well as growth.
2. Restricted use
Not all businesses can use cash-basis accounting. You cannot use cash-basis accounting if you:
- Sell products or services on credit
- Have gross receipts higher than the IRS requirements
- Need inventory to account for income
If you offer credit to customers, you must use accrual accounting. Why? Because offering credit means customers don’t pay right away. You need to be able to record transactions when they take place, not just when you receive the money.
The IRS also sets restrictions on who can use cash-basis accounting. The following cannot use cash-basis accounting:
- C corporations or partnerships with average annual gross receipts for the three preceding tax years exceeding $25 million
According to the IRS, you generally cannot use cash accounting if you produce, purchase, or sell merchandise and rely on inventory. However, there is an exception. If you are a small business taxpayer, you can choose not to keep an inventory if you have average annual gross receipts of $25 million or less for the three preceding tax years.
3. Potentially difficult to switch over
As your business grows, you may decide (or be required) to change accounting methods. To change from cash to accrual, you need to make some adjustments.
When transitioning your accounting books from cash to accrual, you must:
- Add accrued and prepaid expenses
- Add accounts receivable
- Subtract cash payments, cash receipts, and customer prepayments
You must also request a change in your accounting method with the IRS. To do so, file Form 3115, Application for Change in Accounting Method.
Want to be able to see reports in all three accounting methods? With Patriot’s accounting software, you can view reports in cash-basis or modified cash-basis accounting, then download them using the accrual method to give to your accountant. So go ahead, choose the method that works best for you. Get your free trial now!
This article has been updated from its original publication date of September 22, 2014.
This is not intended as legal advice; for more information, please click here.