How Do I Choose between the Cash or Accrual Methods?
Like many things in life, timing is everything when it comes to choosing the best accounting method for your small business. Read on to learn about the differences between cash and accrual accounting methods and decide which is best for your small business!
Choosing Your Method
You'll choose your accounting method the first time you file a tax return, and then you'll continue using this method for your future returns, too. If you would like help with this big decision, we are more than happy to help! You can contact us HERE. Rest assured, however, if you decide to change methods in the future, you can fill out Form 3115 to get IRS approval.
Cash Basis Accounting
With cash accounting, you will track solely when cash is received and when expenses are paid. This method is very transactional and great for smaller companies who don't have long waits between when they provide services and when they are paid.
This method impacts your month-to-month bookkeeping because you will see exactly when cash is flowing in and out. It can also affect your taxes because your income will be taxed upon flowing in. This can be a perk, too! For example, if you perform a job in December but do not receive payment until January, you would not have to pay taxes on the income until the following year. Cash accounting may also be simpler if you don't have inventory to sell or if you have short waiting periods between rendering services and payment.
One major disadvantage of this method, however, is that you do not have a clear picture of outstanding accounts receivables and payables. When planning ahead for major business investments, this can complicated your budgeting plans and can become confusing.
Accrual Basis Accounting
In accrual basis accounting, you record transactions as they are earned regardless of when cash is exchanged. For example, you would record cash inflow when a contract is signed, not necessarily when services are rendered. In contract to the cash method where you would have to wait for the cash, you can see how this method is a bit trickier to navigate.
This method may be better for companies who have projects over longer periods of time. One of the biggest challenges of this method are the difficulties in analyzing cash flow, but that can be easily remedied! Alternatively, one of the biggest upsides of this method is that it gives you a clear picture of long-term finances.
One disadvantage of accrual basis accounting is that it may require a more advanced understanding of financial management and even additional resources to ensure the company stays on top of accounts receivables and accounts payables. In addition, while accrual basis accounting helps with long-term plans, it may be more challenging to analyze short-term goals. However, it may be the best fit for many companies who want to record their accounts payables and receivables.
A Little Bit of Both
Some small businesses can do both types of accounting! For example, a company may use accrual accounting for inventory and cash for their expenses and revenues. If you are struggling with choosing the best accounting method for your small business, let's schedule a meeting to help you!
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Disclaimer: The views presented in this post are meant as educational resources and should not be taken as direct advice for your personal finances or small business. Should you have questions regarding a post relating to your specific finances, please contact us at firstname.lastname@example.org.
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