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Small Business Cash vs Accrual Accounting

Small Business Cash vs Accrual Accounting
Lauren Ward

Lauren Ward

Updated November 11, 2021
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Tracking your small business finances is a crucial part of growing a successful company. There are multiple accounting methods for small businesses. Many companies choose between two of the most common approaches: cash basis accounting vs. accrual basis accounting. Each one has its own way of tracking income and expenses in your accounting books. Cash basis accounting is easier, while accrual accounting gives a more accurate look at your company’s big financial picture. Recommended: Small Business Accounting 101

What Is Cash Basis Accounting?

Cash basis accounting is the easiest accounting method for small businesses. With this method, you record your income and expenses as the transactions are posted to your bank account. It gives you a real-time snapshot of your balance sheet instead of incorporating upcoming accounts receivable and accounts payable. Cash accounting also doesn’t count inventory as an asset, so it’s better suited for businesses that sell services rather than consumer-facing products.In order to use cash basis accounting, your business must have less than $25 million in annual gross receipts for the last three tax years.

Cash Basis Accounting Pros and Cons

Pros

Some advantages of cash accounting are that it’s:Similar to personal budgeting: Cash accounting is done the same way you probably manage your personal finances.Easier to figure taxes: You are taxed only on income received during the tax year.

Cons

Some negatives of cash accounting are:Data lag: Revenue is based on work performed or product sold in the previous month, so it could obscure your true cash flow.Harder to track invoices and expenses: Accounts payable and receivable aren’t tracked with cash flow accounting, so it’s harder to know what invoices are outstanding and what bills are coming up. 

Cash Accounting Example

Here’s a hypothetical situation to illustrate how cash accounting works. If you invoice a client and it takes them 30 days to pay, you would capture the deposit based on the day the funds hit your account, not when you actually billed for the service. The same goes for your expenses. Say you mailed a check to a vendor and it took them two weeks to actually cash it. In your accounting software, that transaction would be counted for the day the funds left your account.When it comes time to file taxes, you count only income and expenses that have actually hit your books, even if you have outstanding invoices and payments that need to be paid in the new year. 

Accrual Basis Accounting

Accrual basis accounting is more complex and separates the company financials from calculating cash flow. Rather than relying on bank transactions, this method tracks when the company is billed by vendors and when customers are invoiced (not when they actually pay). Additionally, anything bought on credit is counted for the day the purchase is made, not when the credit card bill is due. So while your balance sheet doesn’t reflect your bank account, it does reflect that actual movement of transactions in real time. Accrual basis accounting provides a better sense of what’s actually happening in the business at any given moment. Companies with revenue under $25 million can choose cash or accrual accounting for their small business. But once you average more than $25 million in gross receipts annually, you must use accrual basis, accounting to the Generally Accepted Accounting Principles (GAAP), the accounting standard adopted by the U.S. Securities and Exchange Commission. Companies with inventory should also use this method. 

Pros and Cons of Accrual Basis Accounting

Pros

Some benefits of accrual basis accounting are:Provide an accurate snapshot of company financials: Understand how income and expenses impact each other during the window in which they’re actually incurred, not when the transactions post to your bank account.Complies with GAAP: Larger companies (over $25 million in annual revenue) must comply with the Generally Accepted Accounting Principles (GAAP), the accounting standard adopted by the U.S. Securities and Exchange Commission. 

Cons

Some negatives of accrual basis accounting are:It’s more complex: Finding an accountant experienced with accrual basis accounting is important so you can accurately track your company performance.Numbers are different from bank accounts: You (or your accountant) must track your cash flow separately because your balance sheet won’t reflect what’s actually happening in your bank accounts

Example of Accrual Basis Accounting

Let’s look at a hypothetical situation to show how accrual basis accounting works. Say a consulting company worked on a project for a client and invoiced in December 2021 when the work was complete. The client pays the invoice 30 days later, which falls in January of the next year. With accrual basis accounting, the income is recorded for December and is included in the 2021 tax year, even though the money is not received until 2022.

Cash vs Accrual Basis Accounting: Cash Flow

Cash flow is easier to track with cash accounting than with accrual accounting for most small businesses. Because in cash accounting you record transactions as they’re happening, the balance sheet should be an accurate reflection of your bank accounts. This makes it easier to plan for upcoming expenses and payroll, because you know exactly what’s in the bank. It’s harder to track cash flow with accrual accounting because you’re not recording transactions as they occur. Cash flow needs to be a separate calculation, which adds more work for your accountant. 

Cash vs Accrual Basis Accounting: Taxes

Cash accounting is simpler for tax purposes because you’re only taxed on payments received. This method can help lower taxable income because even if work is performed in the current tax year, the income doesn’t count if it isn’t received until the next tax year. With accrual accounting, you still have to pay taxes on outstanding invoices. On the plus side, you can also deduct expenses like payroll, even if paychecks for December work aren’t paid until January.

Is Cash or Accrual Accounting More Common?

How likely small businesses are to use cash vs. accrual basis accounting depends on the type of company. Most sole proprietors use cash accounting when starting a small business. There’s only one person in the company, so it’s easier to track  income and expenses.Once a business grows or reincorporates, accrual accounting becomes the norm. Part of that is because it’s required once your revenue grows over $25 million. Accrual basis also gives management and investors a real-time understanding of what’s happening in the business so they can determine trends and their causes. 

Switching From Cash to Accrual Accounting

Switching from cash to accrual accounting isn’t as simple as updating your software or telling your accountant to make the change. You actually need permission from the IRS (for which you use Form 3115.) You’ll also need to provide the IRS with an adjustment that compares your accrued income and expenses to your cash basis income and expenses.

Looking to Start a Small Business?

It’s smart to put accurate accounting procedures in place when you’re starting a small business. Equally important is getting competitive rates on your financing. Get help from Lantern by SoFi, which gives you access to multiple lenders using one simple form to apply. 

The Takeaway

Both cash and accrual basis accounting help you track your business’s growth. What you choose may depend on the size and complexity of your business but be aware of revenue requirements as well. When your business archives a certain level of revenue, you’ll be required to use accrual basis accounting.Ready to take it to the next level? Compare small business loans using Lantern Credit’s fast and easy platform.
Photo credit: iStock/Иван Карасев
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About the Author

Lauren Ward

Lauren Ward

Lauren Ward is a personal finance expert with nearly a decade of experience writing online content. Her work has appeared on websites such as MSN, Time, and Bankrate. Lauren writes on a variety of personal finance topics for SoFi, including credit and banking.
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