When setting up bookkeeping for your business, two main methods are used to determine when you record income and expenses: cash accounting and accrual accounting. Although other methods of financial record-keeping may be used, we’ll focus on these two methods here.
The method selected should meet the business’s needs and reflect the business operations.
Smaller businesses can choose the best accounting method. Let’s explore the differences between cash and accrual accounting to establish which method will best meet their business needs.
Cash Accounting
Cash accounting is a straightforward method of recording financial transactions based on actual cash flow. This method works very well for businesses that are paid when they provide their goods or services. No account receivable is necessary.
Under this system, revenue is recognized when cash is received for goods or services, and expenses are recognized when they are paid. It focuses solely on the cash movement in and out of the business, providing a clear picture of available funds. There is no need for accounts receivable or accounts payable for operating activities.
Key Features of Cash Accounting
- Simplicity: Cash accounting is simple to understand and implement because it doesn’t require extensive accounting knowledge. It’s ideal for solo entrepreneurs and small businesses with straightforward pay-as-you-go financial transactions.
- Real-Time Cash Flow: Cash accounting provides a real-time view of your business’s cash flow. It helps you understand the cash available at any moment, allowing you to make informed decisions regarding expenditures, investments, and financial planning.
- Tax Reporting: The IRS allows individuals and certain small businesses to use the cash accounting method. Cash accounting is an excellent option for solo entrepreneurs, freelancers, contract workers, or self-employed individuals who do their own bookkeeping and tax returns.
Accrual Accounting
Accrual accounting, on the other hand, focuses on recognizing revenue when it is earned and expenses when they are incurred, regardless of cash flow. It provides a more comprehensive view of a business’s financial position by considering accounts receivable, accounts payable, and non-cash transactions.
Businesses that sell to customers on a credit basis can create a receivable account and recognize the income immediately, even though the customer will pay later. The same process can be done when purchasing supplies or other expenses on credit that are needed to operate the business. The expense will be recognized when the transaction happens, regardless of when it’s paid.
A drawback of accrual accounting is that it can be more complex because accounts must be adjusted at the end of the accounting period.
For example, prepaid expenses that span two accounting cycles will need to be adjusted so that the correct amount of the expense is recognized as it applies to the accounting cycle.
An excellent example is a twelve-month insurance policy purchased or renewed mid-year. It provides a few months of coverage for this year. The remainder of the policy provides a few months of coverage for next year. The cost of the policy will be accounted for as a prepaid asset that will need to be adjusted at the end of the year to reflect the amount that is an expense for the current year.
Example:
You’ve purchased your new business insurance policy on May 1. It will be renewed again at the end of April next year. You’ll use up eight months of the twelve-month policy this year.
Instead of claiming the entire amount of $1,000 as an expense this year, you’ll only claim the amount of the policy you’ve used for eight months. That means $333 will carry over to next year’s expenses.
($1000/12) x 8 months = $667 (rounded)
May 1 Prepaid Business Insurance $1,000
Cash $1,000
Dec 31 Business Insurance Expense $667
Prepaid Business Insurance $667
Key Features of Accrual Accounting
- Accurate Financial Picture: Accrual accounting accurately represents a business’s financial health over a specific period. It matches revenue with the corresponding expenses, allowing for a better assessment of profitability and performance.
- Long-Term Planning: Accrual accounting helps with long-term financial planning. It enables businesses to anticipate future cash flow needs, identify potential issues, and plan accordingly.
- Compliance and Financial Reporting: Many businesses, particularly larger ones, must use accrual accounting for compliance purposes. Accrual-based financial statements are often necessary for external reporting, such as tax filings, audits, and loan applications.
Tax Implications of the Two Accounting Methods
Each accounting method is defined by when your business recognizes income and expenses. This timing factor will have an impact on your tax return. The following examples will show you how to treat income for each method.
Cash Accounting Example
Jae is a freelance wedding photographer who uses the cash accounting method. She photographs weddings on weekends when she’s not working her full-time job. After the wedding, she provides the couple with digital watermarked proofs so they can choose the photos they’d like to purchase. Jae makes necessary edits to the selected pictures. The couple will pay Jae when the final digital copies are delivered.
Jae photographed five weddings in 2024. She was paid $4,000 for four of the weddings. Jae finished the photos from the fifth wedding and billed the couple $1,000 on December 30, 2024. The couple paid Jae on January 3, 2025, and downloaded the photos.
Jae will report $4,000 of income for her business on her 2024 tax return. The $1,000 for the fifth wedding will be reported on her 2025 tax return since that’s when she received the payment.
Accrual Accounting Example
Assume the same facts from the above example, except that Jae uses the accrual method of accounting.
Jae has effectively earned the income for the fifth wedding. She has completed the service, provided the photographs, and billed the customer. Although Jae doesn’t receive payment until January 2025, she will “accrue” the earned income from December and report $5,000 on her 2024 tax return.
Choosing the Right Method for Your Business
Selecting the appropriate accounting method depends on various factors, including the size and nature of your business, industry standards, and legal requirements. Consider the following when making your decision:
- Size and Complexity: Cash accounting is more suitable for small businesses with straightforward financial transactions, while accrual accounting is often necessary for larger organizations with more complex operations.
- Industry Standards: Certain industries, such as manufacturing or construction, may require accrual accounting to comply with industry-specific regulations or reporting standards.
- Tax Considerations: Assess the tax implications of each method. Cash accounting can provide short-term tax advantages, but accrual accounting may offer better long-term tax planning opportunities.
Conclusion
Cash and accrual are two distinct methods of accounting. Cash accounting offers simplicity and real-time cash flow visibility, making it ideal for small businesses. Accrual accounting provides a more comprehensive financial picture, aiding long-term planning and compliance.
Choose the accounting method that aligns with your business’s size, complexity, and specific requirements. Remember, consulting with a financial professional can help you make an informed decision tailored to your unique circumstances.
