Cash Accounting or Accrual Accounting - Which to Use?
Cash Accounting vs. Accrual Accounting - Which Should I Use?
Every business, small or large, must make a decision about how and when to record income and expenses. The two options for this recording are called "cash" and "accrual."
For tax purposes, you will need to make this decision for your business before you file your first business tax return.
How Cash Accounting Works
In cash accounting, a transaction is recorded when money actually changes hands.
Income is recorded when you receive the money and expenses are recorded when they are paid.
Example 1: For an income transaction, if you perform a service and bill a client, you record the income for cash accounting purposes only when you have received the payment for that service. If you send out an invoice on August 12 and you don't receive payment until September 1, you record the payment on September 1.
Example 2: For an expense transaction, you might receive a bill for phone service, but in cash accounting you don't record the expense until you have actually paid the bill. if you receive a bill on August 15 and you don't pay the bill until September 1, you don't record the expense until September 1.
Pro and Con: Cash accounting is simpler to remember and record, since it follows your business checking account. When a sale is recorded in your checking account, it's recorded in your business.
But the cash accounting method may not show the real picture of your business activity, since the month you were busy or slow is different from the month when you received the money.
How Accrual Accounting Works
In accrual accounting, the transaction is recorded when it is earned (established) by sending out an invoice or receiving a bill.
In Example 1: For an income transaction, using the accrual method, you would record the income when the work is complete or the product has been received; that is, you have earned the payment. In the examples above, income to you is recorded when you send out the bill, even though you have not yet been paid. The expense is recorded when you receive the bill, even though you have not paid.
In Example 2: For an expense transaction. When you receive a bill for an expense, it's considered an expense for tax purposes. So you can deduct it for that year, even if you haven't paid the bill yet.
Pro and Con: Accrual accounting is more confusing, but it shows your monthly business activity more accurately.
Setting Your Accounting Method
Most small companies use the cash method of accounting, because it is simpler and easier to determine when to record income and expenses. You must use the accrual method if
- your business has sales of more than $5 million per year, or
- your business stocks an inventory of items that you will sell to the public and your gross receipts are over $1 million per year.
The IRS says:
"Generally, if you produce, purchase, or sell merchandise, you must keep an inventory and use an accrual method for sales and purchases of merchandise."
Inventory includes any merchandise you sell, as well as supplies that will physically become part of an item intended for sale.
End of Year Transactions and Accounting Method
At the end of your fiscal year, cash and accrual accounting must be considered in the timing of transactions. Here is how:
- Income If you are on accrual accounting and you want income in the current year, send out bills before the end of the year. If you want to delay income, don't send out bills until after the start of the next year. For cash accounting, pay the bill in the year when you expect the lowest total income.
- Expenses Take on expenses in the year when you want those expenses to be counted, to minimize your taxes. You don't necessarily have to pay the bill in that year, if you are using accrual accounting.
Un-collectible Bills/Bad Debts
Under the accrual method, if you have customers who haven't paid you, you may be able to write off, or reduce your taxes for, these bad debts.
As an example, let's say you have a client you invoiced in February. You have made repeated attempts to collect the money and have finally decided that this client is not going to pay. If you are using the accrual accounting method, you have already recorded the sale. Before the end of the year, you may take take this un-collectible amount from your income, thus reducing your gross income and your tax liability.
For More Information
For more information on IRS restrictions on accounting methods, see this section of IRS Publication 538: Accounting Periods and Methods.
Disclaimer: The information in this article is not intended to be tax or legal advice. If you are unsure about which accounting method to select, check with your professional tax advisor.