For a small business, you can use one of two possible accounting systems: cash accounting and accrual accounting.
The two differ in the timing of when revenue and expenses are reflected in your accounts. Cash accounting recognizes expenses and revenue when the funds change hands, while accrual accounting recognizes them when they are incurred. The cash method of accounting is generally suitable for very small businesses without any inventory. The accrual method is more popular and conforms to the generally accepted accounting principles (GAAP).
Learn more about how cash accounting and accrual accounting work and which method may be best for you.
- Cash accounting means you state revenue and expenses based on when cash changes hands, while accrual accounting means you state revenue and expenses when the transactions occur.
- As a result of the Tax Cuts and Jobs Act (TCJA), small business taxpayers with average annual gross receipts of $25 million or less in the prior three-year period can use the cash method of accounting.
- Typically, cash accounting is only appropriate for small service businesses that carry no inventory.
- Accrual accounting is considered a more accurate method, as it gives a clearer long-term picture of your business.
What’s the Difference Between Cash Accounting and Accrual Accounting?
When someone files a business’s first tax return, they choose which accounting method they want to use. The following table shows, at a glance, the key differences between cash and accrual accounting:
|Cash Accounting||Accrual Accounting|
|Timing||Revenue and expenses are stated when cash exchanges hands||Revenue and expenses are stated when the transaction occurs|
|Accuracy||Considered less accurate because it doesn’t see unpaid bills that are coming||Considered more accurate because it gives a clearer long-term picture of your business|
|Complexity||Simple||More complex due to tracking more accounts|
|Best for||Very small service businesses||Small businesses that carry inventory or have had average annual gross receipts of $25 million or more for the three preceding tax years|
Cash accounting occurs when revenue and expenses are stated at the time money changes hands. Accrual accounting, however, occurs when the revenue and expenses are incurred—which is significantly different. Cash accounting offers a picture of the business at one particular point in time. Accrual accounting offers a better picture of the financial health of the business over a period of time.
Before 2017, small-business taxpayers with average annual gross receipts of $5 million or less in the preceding three-year period could use the cash method. The enactment of the Tax Cuts and Jobs Act (TCJA), however, made it possible for more small businesses to use the cash method. The TCJA allows small business taxpayers with average annual gross receipts of $25 million or less in the prior three-year period to use the cash method of accounting. If your business makes more than that, you must use the accrual method.
Accrual accounting is generally considered to provide a more accurate long-term picture of the firm’s financial health. With this method, companies look at both current and expected cash flow projections, while cash accounting does not recognize unpaid bills that are coming. Accrual accounting is effective in smoothing out revenue over time. The downside of accrual accounting is the fact that it is associated with the risk of bad debt because the revenues are not collected yet even though they are incurred and invoiced. Moreover, the advantage of smoothening revenues can turn into opportunities for accounting shenanigans if it is practiced in excess.
Cash accounting is simple for a small business, as it’s just like taking care of your checkbook. Accrual accounting is more complex since you have to keep track of more accounts.
Accrual accounting requires the business to follow the Generally Accepted Accounting Principles (GAAP).
Which Is Best for Your Business?
Cash accounting is used by many small businesses because of its simplicity. Income and expenses are recorded in your books only when the cash hits your account or leaves it.
Small-business taxpayers with average annual gross receipts of $25 million or less in the prior three-year period can use the cash method of accounting. The cash method is best for small service businesses with low inventory, while the accrual method of accounting is best for large businesses with complex practices.
Businesses with average annual gross receipts of more than $25 million for the prior three years must use the accrual accounting method. This method tends to offer a more accurate long-term view of your business finances, which allows you to see what income and expenses you have yet to earn or pay.
A Best-of-Both Worlds Option
At times, it makes sense for businesses to use both cash and accrual accounting. This is called the hybrid method of accounting.
The hybrid accounting method makes it possible to track cash flow and get a long-term view of the firm’s financial health. However, according to the IRS, you must follow a few restrictions when using the hybrid method:
- When inventory is necessary to account for your income, a business must use the accrual method for purchases and sales.
- If a business uses the cash method to report income, it must also use the cash method to report expenses.
- If you use the accrual method for reporting expenses, you must also use the accrual method for figuring out income.
- Any combination of reporting that includes the cash method is treated as the cash method, according to the Internal Revenue Code.
The hybrid method allows you to use cash accounting for most transactions, but certain line items, like inventory, may require the use of accrual accounting. The hybrid method can be complex, so only use it if it is required or if you have some accounting skills. If you aren’t skilled in accounting, speak with a CPA for assistance and read IRS Publication 538.
The Bottom Line
Cash and accrual accounting are accounting methods appropriate for different companies, industries, and situations. Cash accounting recognizes revenue and expenses when money changes hands. Accrual accounting recognizes revenue and expenses when they are incurred. The hybrid method uses elements of both.
To choose your method of accounting, you must compare your business situation to the rules for accounting stated by the IRS.
Frequently Asked Questions (FAQs)
Should an agricultural business use cash or accrual accounting?
Most agricultural businesses use cash accounting to balance out volatility in the agricultural markets and manage operations consistent with cash flow. If farmers have to switch to accrual accounting, it would penalize them in an industry with high price volatility, rising production costs, and thin margins.
How does cash vs. accrual accounting affect payroll?
If a small business has employees, it has a payroll. The payroll of a business involves an Accrued Payroll account, a type of accrued expense. All money earned by employees shows up in that account, which is a liability on the balance sheet. Most small businesses with payroll use accrual accounting, since payroll has both an accrued account and an expense account.
Which financial statements are the most affected by accounting methods?
The income statement is sensitive to stating income and expenses as they are paid or incurred. The balance sheet, on the other hand, has accounts like accrued liabilities or accrued payroll, which are also sensitive to the accounting method chosen. The statement of cash flows is affected by your choice of accounting method since net income will differ depending on the method chosen.
Congressional Research Service. “Cash vs. Accrual Basis of Accounting: An Introduction,” Page 3.