We’ll look at both methods in detail, and how each one would affect your business.
Cash basis accounting
Many small businesses opt to use the cash basis of accounting because it is simple to maintain. It’s easy to determine when a transaction has occurred (the money is in the bank or out of the bank) and there is no need to track receivables or payables.
The cash method is also beneficial in terms of tracking how much cash the business actually has at any given time; you can look at your bank balance and understand the exact resources at your disposal.
Also, since transactions aren’t recorded until the cash is received or paid, the business’s income isn’t taxed until it’s in the bank.
Accrual basis accounting
Accrual accounting is a method of accounting where revenues and expenses are recorded when they are earned, regardless of when the money is actually received or paid. For example, you would record revenue when a project is complete, rather than when you get paid. This method is more commonly used than the cash method.
The upside is that the accrual basis gives a more realistic idea of income and expenses during a period of time, therefore providing a long-term picture of the business that cash accounting can’t provide.
The downside is that accrual accounting doesn’t provide any awareness of cash flow; a business can appear to be very profitable while in reality it has empty bank accounts. Accrual basis accounting without careful monitoring of cash flow can have potentially devastating consequences.
Note that many businesses do their bookkeeping on a cash basis but file taxes on an accrual basis. They take the steps to convert cash basis accounting to accrual basis once it’s time to do tax prep.
What it means to “record transactions”
We’ve talked a lot so far about recording transactions in your books, and how cash and accrual dictates “when” you do that.
But what does it mean to record a transaction?
Every business has to record all its financial transactions in a ledger—otherwise known as bookkeeping. You’ll need to do this if you want to claim tax deductions at the end of the year. And you’ll need one central place to add up all your income and expenses (you’ll need this info to file your taxes).
There are some good DIY bookkeeping options out there. Or if you’d rather have someone else do your bookkeeping for you, check out Bench.
Diagram comparing accrual and cash accounting
The effects of cash and accrual accounting
Understanding the difference between cash and accrual accounting is important, but it’s also necessary to put this into context by looking at the direct effects of each method.
Let’s look at an example of how cash and accrual accounting affect the bottom line differently.
Imagine you perform the following transactions in a month of business:
- Sent out an invoice for $5,000 for a web design project completed this month
- Received a bill for $1,000 in developer fees for work done this month
- Paid $75 in fees for a bill you received last month
- Received $1,000 from a client for a project that was invoiced last month
The effect on cash flow
Using the cash basis method, the profit for this month would be $925 ($1,000 in income minus $75 in fees).
Using the accrual method, the profit for this month would be $4,000 ($5,000 in income minus $1,000 in developer fees).
This example displays how the appearance of income stream and cash flow can be affected by the accounting process that is used.
The effect on taxes
Now imagine that the above example took place between November and December of 2017. One of the differences between cash and accrual accounting is that they affect which tax year income and expenses are recorded in.
Using cash basis accounting, income is recorded when you receive it, whereas with the accrual method, income is recorded when you earn it.
Following the above example, using accrual accounting, if you invoice a client for $5,000 in December of 2017, you would record that transaction as a part of your 2017 income (and thus pay taxes on it), even if you end up receiving the payment in January of 2018.
Further Reading: A Small Business Tax Checklist
Should a small business use cash or accrual accounting?
If your business doesn’t hit those criteria, you’re welcome to use the cash method.
That being said, the cash method usually works better for smaller businesses that don’t carry inventory. If you’re an inventory-heavy business, your accountant will probably recommend you go with the accrual method.
To change accounting methods, you need to file Form 3115 to get approval from the IRS.
(If you’re in Canada, the CRA offers guidance on how to change methods here.)
Further Reading: Small Business Accounting 101: A Guide for New Entrepreneurs