When you start a new business, one of many major decisions you will have to make is how to set up your bookkeeping Part of that decision is a determination of what type of accounting method you want to you. Consider these facts in your selection.
Cash Accounting Method
The difference between accrual accounting and cash accounting pivots on when income and expenses are recorded. With the cash method, the money is accounted for when the income is received, or the expenses are paid. With this type of accounting accounts receivable and accounts payable are not considered in the profits or losses for the business.
Here is an example of cash-basis accounting. If Company XYZ buys freelance services from Mary, the transaction would not be recorded until the company pays Mary’s invoice. In the same vein of thought, Company XYZ would not record the sale of the finished product to Customer Zee until Customer Zee pays Company XYZ’s invoice.
Cash-based accounting is much simpler to maintain than accrual accounting, and it provides a more accurate cash flow picture. In other words, the income after expenses reported on your financial statement should agree to the balance in your bank account. Income is not taxed until the income is actually received. This makes it easy for a company to defer taxable income by either delaying billing until the next calendar or fiscal year. It can so reduce the income for a given year by paying bills early rather than waiting for the due date. While cash-based accounting creates a more accurate cash flow projection, it tends to muddy the company’s actual financial picture.
The cash-based method works best for small businesses with little or no inventories or companies that specialize in providing services because it does not equitably match the costs of inventory to the income earned.
IRS Regulated Usage
Since this type of accounting can skew the true financial picture, the IRS has strict regulations that spell out which companies can use cash basis accounting.
- C corporations and partnerships averaging less than $5 million in gross receipts annually
- Sole proprietorships and S corporations averaging less than $1 million in gross receipts annually
- Family-owned farms averaging less than $25 million in gross receipts annually
- Must not need to make financial disclosures to the IRS
- Must not be publicly traded
- Must not maintain an inventory
Businesses That Benefit from Cash Accounting
In general, cash accounting works best for small sole proprietorships and partnerships. Examples of business types include:
- Child care services
- Pet grooming
- Tax return preparation
- Real estate appraiser
Hybrid Cash Accounting Systems
While cash-bases and accrual basis are the two primary types of accounting systems, some businesses operate using a hybrid system. Modified cash basis accounting differs from cash basis because it includes long-term assets and liabilities on the balance sheet.
Accrual Accounting Method
Opposed to the cash method, in accrual accounting, the company records expenses when they are incurred regardless of when the bill is paid. Income is recorded when it is invoiced regardless of when it is paid.
Here is an example of accrual accounting. When Company XYZ buys inventory from Mary’s Business Forms, Company XYZ records the account payable when the inventory is received regardless of when the invoice is paid. When Company XYZ resells those forms to Customer Zee, the transaction is recorded as an account receivable when the forms are sold regardless of when Customer Zee pays the bill.
Many businesses prefer accrual accounting because it best matches the expenses of maintaining an inventory to the income derived from the sale of that inventory. This makes it easier to track the performance of the company and tracking trends in sales and expenses.
On the downside, the average business will send out an invoice to the customer and give the customer 30 days to pay the bill. This can dramatically affect cash flows, especially if a few key customers fail to pay within 30 days. In effect on paper, a business can look profitable because the products are selling, but it may have little money in the bank. Accrual accounting is more complicated and time-consuming. It requires a high degree of accuracy in order to make the most out of the financial analysis capabilities. Additionally, accrual accounting takes into consideration the value of your outstanding account receivable and the liability of unpaid accounts receivable.
Businesses That Benefit from Accrual Accounting
Accrual accounting is ideal for businesses to maintain an inventory or offer credit terms to customers. It is also an alternative when IRS regulations prohibit the use of cash-based accounting.
Some specific business-types that benefit from accrual accounting include:
- Automobile dealerships
- Software sales
Changing Accounting Methods
The good news is if you choose one method and later decide it does not work for you, you can change methods. In fact, the IRS expects a business to change methods from cash to accrual whenever the business no longer meets the regulations to use cash accounting. When an accounting system is changed, the company must file a Form 3115, Application for Change in Accounting Method, with the IRS and pay a fee.
The process to change methods is not easy, particularly for a larger business. Even if you are accustomed to doing your accounting in house, you may want to hire an accounting service to assist with the conversion. Accrual accounting services can bridge the gap between cash and accrual accounting as well as train in-house staff on the new accounting procedures. Their expertise can ensure the conversion process leaves you with an accurate set of financial records and protect your employees’ time to deal with the day-to-day transactions that continue to need attention.
Deciding on which of the accounting methods is best for a small business is an art. Most accounting firms offer both cash and accrual accounting services, but the end decision on which method is right for your company is us to you. By understanding the difference between the two methods, you are taking the first step to make a wise decision.