Taxes and Accounting

Cash- vs. accrual-basis accounting for small business

Find out which method is a better fit for your business.

The accounting method you use — either cash- or accrual-basis — shapes the way you track your business financials. Before you choose one method, learn about the benefits, requirements and tax-related impact of each.

Understanding how they differ

The primary difference between cash and accrual accounting is when you record a transaction and the associated income. With cash accounting, you record income only when you receive payment from customers — whether they pay with cash, credit card, check or another payment method.

Likewise, expenses are recorded only when the cash leaves your bank account. For example, if you buy a product or acquire a service using trade credit, that expense will only be recognized when your business has actually paid off that debt using its cash.

Using the accrual method, revenues are recognized at the time a transaction takes place — regardless of when payment is received. For example, if your business sells 100 units of a product or provides a service, the revenue is recorded at the time of sale or when the service is delivered, regardless of when the customer actually pays you.

Similarly, expenses are logged at the time your business makes a purchase, not when cash leaves your bank account. In this case, you would account for a purchase that your business makes using trade credit at the time of purchase, not when the account is actually paid off.

Choosing the best method

The primary benefit to the accrual method is that it helps you align your income and expenses within a given time period. The accrual method can help you track patterns in business income and expenses more accurately, but does not always provide a clear picture of cash on hand. For instance, your books may show a growth in sales, but you may not appreciate that cash reserves are running low because you haven't received payment for the sales yet.

The primary benefit to the cash method is that it's easier to gauge your available cash. However, since this method doesn't necessarily help you match income and expenses for a given month or year, it can make assessing long-term profitability more difficult. For example, you could see a large influx of cash in one month — but this may be the result of customers paying older debts rather than representing a surge in profitability.

Although many individuals and small businesses use cash-basis accounting, the Internal Revenue Service has rules which may dictate the use of the accrual method for your business.

Considering tax implications

The method of accounting you use does impact how you report your business taxes. With the cash-basis method of accounting, you must record and report income the year it is received rather than when the product or service was supplied. For instance, if you perform a service for a customer in 2016 but that customer doesn't pay for the service until 2017, that income wouldn't be included in your 2016 income under the cash-basis method. However, under the accrual-basis method, that income would be included in your 2016 income because that is when the service was performed.

With the cash-basis method you can only take deductions for qualified business expenses in years where payments were actually made. For example, if you order office equipment in 2016 but don't pay for that equipment until 2017, a deduction can't be applied to the 2016 tax year. With the accrual method, you would apply the deduction in 2016 because that's when the equipment was delivered and billed.

The summary above only introduces a basic understanding of the two accounting methods. You should consult your tax advisor for a complete evaluation of the pros and cons associated with each accounting method and of your business's specific situation.