One of the most vital elements of running a business is keeping track of expenses and revenue; if you currently own a business or are interested in doing so in the future, it’s important to use a method of accounting that best suits your business needs.
There are two main methods of accounting: the accrual method and the cash basis method. Let’s explore the differences between the two.
What's the difference?
The main difference between these two accounting methods is the timing of when expenses and revenue are recorded.
Under a cash-based method, transactions are only recorded when cash is actually received or dispensed. It is the simpler method of the two.
In contrast, under an accrual accounting method, transactions are recorded as they occur but before money is received or dispensed. In other words, revenue is accounted for as it is earned, rather than when it is received. This revenue is called accounts receivable. Similarly, expenses are recorded as they are incurred rather than when they are paid; these are termed accounts payable.
While cash-based accounting tracks cashflow, showing a more accurate snapshot of a business’s finances at the present moment, accrual accounting anticipates a business’s future financial state and therefore offers a more accurate long-term picture of the business’s finances.
Can a business use either accounting method?
Typically, sole proprietorships and other small business structures use the cash basis method of accounting because it is simple to maintain and keep track of expenses and revenue without having to track accounts receivable or accounts payable.
Larger business entities most often use the accrual method. In fact, the IRS requires certain businesses to use this method, though some businesses may be eligible to use a hybrid method that incorporates elements of both cash-based and accrual accounting.
If your business produces, purchases, or sells merchandise, you are generally required to keep an inventory and use an accrual method for sales and purchases of merchandise.
The following types of business entities are prohibited from using the cash-based method of accounting:
A partnership that includes a corporation as partner (unless the corporation is an S-corp)
Tax shelters
Because they are prohibited from using cash-based accounting, these entities must use the accrual method instead.
Are there downsides to using either accounting method?
There are some downsides to both types of accounting.
While the cash-based method provides a more accurate snapshot of a business’s cash flow at that moment in time, because accounts payable (impending expenses) are not tracked, a business may appear to be healthy due to its cash flow while in reality facing impending financial difficulty not currently reflected by its accounting records.
Accrual accounting presents a few challenges. Because this method doesn’t track cash flow, a business may appear profitable based on accounts receivable records while facing a shortage of cash in the short term.
Because the accrual method is more complicated than the cash-based method, it may require a business to hire additional staff to track accounts payable and receivable. Using this method can also lead to more complicated taxes, as the IRS has special rules for certain tax situations arising from accrual accounting.
In summary, the main difference between these two main accounting methods is when transactions are recorded. Which method is right for your business depends on a number of factors. If you have questions about which type of accounting method to employ within your business, contact your CPA today.
