Learn about the differences between cash and accrual accounting before you decide which method to use for your small business.
- Cash accounting is used by most individuals for their personal accounting.
- The accrual method recognizes credits and debits, regardless of whether or not a monetary transaction has been made.
- If you switch from cash to accrual accounting, you will need to receive permission from the IRS.
Cash and accrual accounting are financial reporting methods that share a similar function of recording sales and purchases. However, when it comes to how they operate, their processes differ in when and how you record transactions in your accounting software.
Every small business is different, so it's important to understand the difference between cash and accrual accounting so you can make an informed decision and choose the best option for your company. Here's what you should know about these two accounting methods.
What is cash accounting?
Cash accounting 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. This kind of financial reporting is usually used by sole proprietors and businesses without inventory. Compared to the accrual method, cash accounting is easier to manage and keep track of because you only record transactions when money enters or leaves your business. [Check out these 9 Accounting Tasks You Should Do Every Day.]
If you use this method of accounting 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 hands over the cash to pay for it.
This can affect how you assess the financial standing of your company because of the way information is recorded. It can also make it difficult to track profit trends. However, with cash accounting, you're able to predict future spending.
What is an example of cash accounting?
Let's say a company receives $20,000 in sales from five pieces of merchandise they sold to another company on May 1. Although the order was placed a month before, the sale would be recorded for May 1, because that is the day they received the payment for it.
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What is accrual accounting?
The accrual method recognizes credits and debits, so you record transactions when you have a legal right to the cash, regardless of whether or not a monetary transaction has been made. Companies that are obligated to use accrual accounting usually carry inventory and are C corporations – meaning their owners, or shareholders, are taxed separately.
"Accrual is designed to achieve the accounting goal of matching revenue and expenses in the same time period," Charles Read, a certified public accountant and president and CEO of GetPayroll, told Business News Daily. "Accrual is necessary in some industries, but it adds additional complexity, and for small business does not add much clarity to the financial statements or tax returns."
Although accrual accounting provides a more accurate depiction of your company's finances, it has its faults. It doesn't follow a cash flow rule like cash accounting, so sometimes there are cash flow inaccuracies. The cash flow statements show business sales that were made as revenue without considering whether customers have remitted payment or not.
Your annual tax reporting can also be affected. When sales are reported within the year they're made, you can incur an income tax obligation on money you don't have. [Read related article: Choosing the Right Small Business Accounting Software]
What is an example of accrual accounting?
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 paid.
As an item is used up or sold, the inventory, which is the accrual item, is drawn down and expensed, Read said. Even though you paid for the inventory in full, it still has to be counted, valued and removed from expenses.
"One accrual going the other way is payroll," Read said. "At the end of the year, you may well have a payroll that is earned within hours before midnight Dec. 31 but won't be paid until the first paycheck in January. If you accrue payroll, then you calculate the expense that will be incurred for those December hours, and add that as an expense to your tax deductions and income statement even though you have not paid out cash."
The accrual accounting method more accurately shows "the big picture" of a company's financial situation, enabling small business to better understand whether it is making or losing money, said Jerold Zimmerman, an emeritus professor of accounting from 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 said.
Should small businesses use cash or accrual accounting?
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.
"I always recommend cash for small businesses, if possible," Read said. "It is so much easier. Money in and money out. You add up the receipts, and you have revenue. You take all the checks you have written, never disburse cash if you can avoid it, categorize them, and you have the expenses by type."
In the accrual method, a company's 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 that he can't make payroll.
Eventually, Zimmerman pointed out, the accrual and cash accounting methods yield the exact same bottom lines – assuming you can collect all of your accounts receivables.
A small business may benefit more from one method over 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.
Can you switch from cash to accrual?
The short answer is yes, but when it comes to making the actual switch, you need permission from the IRS, and the steps can be lengthy. Here are the things you must do before switching your books from cash to accrual accounting.
1. Add up your accrued and prepaid expenses.
These are expenses you've incurred but haven't paid for yet. Record these unpaid expenses. For your prepaid expenses, move them to an asset account. For expenses made in previous periods, adjust the beginning retained earnings.
2. Add accounts receivable.
When converting your account receivables, in order to switch to accrual, add the unpaid customer invoices to your books. After the invoices are paid, put them in the revenue account.
3. Subtract cash payments and cash receipts.
When switching to accrual, subtract cash receipts, cash payments and customer prepayments. Move the cash payments to the previous period. Then when subtracting cash receipts, modify the existing period's earnings.
4. Subtract customer prepayments.
For customer prepayments, put them down as short-term liabilities until you deliver the goods or provide the service.
After making the proper modifications, fill out Form 3115. This IRS document allows you to request a change in your overall method of accounting or accounting treatment of any item. You must attach your profit and loss statement and balance sheets from the year before as well.
When you are filing for the automatic change option, you must fill out all three parts of the form. If you qualify, you are given automatic approval by the IRS.
Why switch to accrual accounting?
The reason some small business owners find the need to switch from cash to accrual is because of the benefits and accuracy the system provides. It gives you an exact layout and understanding of your company based on the transactions which are recorded immediately, even if there isn't a settlement in cash. Having this understanding helps you assess your company's performance and finances, and prepare for the future.
Additional reporting by John Magee. Some source interviews were conducted for a previous version of this article.