The cash accounting method is used by most individuals for their personal accounting. It entails recording an income or expenditure only when money comes into or leaves your company’s coffers.
If you use the cash method for your business, your company’s accounting records will reflect the income for a product you sell only when payment is received for that product. Likewise, your records will recognize an expense only when your company actually hands over the cash.
The accrual method recognizes credits and debits when you have a legal right to the cash, regardless of whether or not you have actually made a monetary transaction.
A plumber using the accrual accounting method, for instance, records the expected payment in his books as soon as the job is finished, even if the client has yet to hand over the money. So, too, would a bakery record the pallet of flour it ordered as an expense as soon as the expense is incurred, not when it is actually paid.
The accrual accounting method more accurately shows “the big picture” of a company’s financial situation, enabling a small business to better understand whether it is making or losing money, said Jerold Zimmerman, Professor of Accounting at the University of Rochester’s Simon Graduate School of Business.
“A lot of small businesses are run by the owner looking at his checking account going up or down, and that can give you a very misleading impression of the sustainability of the business,” Zimmerman told BusinessNewsDaily.
So, cash or accrual?
While it is generally agreed that the accrual method is preferable for most small businesses, particularly those selling goods rather than services, businesses with little cash on hand may want to stick with the cash method so cash flow problems do not cripple operations. In the accrual method, a companyâs recordkeeping might indicate soaring revenues when in reality its bank account is completely empty. While the accounting may be technically accurate, the owner might be surprised to learn he can't make payroll this week.
Eventually, Zimmerman pointed out, the accrual and cash accounting methods will yield the exact same bottom lines — assuming you are able to collect all of your accounts receivables.
A small business may benefit from one method vs. the other when it comes to tax deductions. If your business uses the accrual method, for example, you might claim deductions for business expenses in a given tax year even if you will not be paying those expenses until the following tax year.
When picking an accounting method for your small business, choose carefully. While it is possible to change which method your company employs, you need permission to do so from the IRS.
More information can be found at the IRS’ Small Business and Self Employed Tax Center.