Skip to main content

Choosing the right accounting method is a key decision for both high-income businesses. Cash and accrual basis accounting represent two distinct approaches to tracking income and expenses, each with its own advantages. Understanding how these methods differ can help clarify which is better suited to your financial situation or business operations. By exploring the features and applications of cash and accrual accounting, you can gain insight into their impact on financial planning and reporting.

What is the Accrual Method of Accounting?

When using the accrual method of accounting, revenue is recognized when it is earned, not when the cash is received. This principle is based on the idea that income and expenses should be matched to the period in which they are incurred, giving a more accurate picture of the business’s financial performance.

For example, let’s say your business provides consulting services. On December 1st, you complete a project for a client and issue an invoice for $10,000, giving the client 30 days to pay. This method ensures your revenue aligns with the work performed, even if the payment isn’t immediately received. 

This approach is particularly helpful for businesses seeking financing or investment, as it provides a more comprehensive financial picture. Investors or lenders can see how much revenue has been earned and how much is expected to be received, allowing for better decision-making. However, there’s a potential downside: if the client fails to pay or delays payment, your financial reports might show revenue that isn’t yet in your cash flow, which can create challenges for short-term cash management.

Pros of the Accrual Method

  • Aligns revenues and expenses, providing a clear financial picture.
  • Offers real-time accuracy of financial health.
  • Facilitates long-term strategic planning.
  • Aligns with Generally Accepted Accounting Principles (GAAP), required for certain businesses over a revenue threshold.

Cons of the Accrual Method

  • Aligns revenues and expenses, providing a clear financial picture.
  • Offers real-time accuracy of financial health.
  • Facilitates long-term strategic planning.
  • Aligns with Generally Accepted Accounting Principles (GAAP), which is required for certain businesses over a revenue threshold.
  • Required for tax purposes for most businesses once they exceed a certain revenue threshold, as per IRS guidelines.

The accrual method offers significant advantages for businesses seeking a comprehensive view of their financial position, particularly when planning for growth or compliance with regulatory standards.

When to Use the Accrual Method

Consider the accrual method if you:

  • Maintain inventory (with some exceptions).
  • Generate more than $30 million in average annual gross receipts (as per IRS guidelines).
  • Need detailed financial records for strategic planning.
  • Seek financing or investors who require detailed statements.

What is the Cash Method of Accounting?

The cash method records income and expenses only when money is received or paid. This straightforward approach is easier to manage and reflects your cash position accurately.

Pros of the Cash Method

  • Simplifies cash flow tracking, showing available funds in real time.
  • Easy to implement and maintain.
  • Facilitates tax planning by enabling you to accelerate expenses or defer income.

Cons of the Cash Method

  • Less accurate financial snapshots, as deferred expenses may overstate profitability.
  • Revenues and expenses may not align, creating potential misinterpretations.
  • Limited use for certain businesses, such as those with substantial inventory or large annual gross receipts.
  • May not meet the expectations of investors or lenders seeking comprehensive financial insights.

When to Use the Cash Method

The cash method may be a good fit for your business if you:

  • Operate as a small business or sole proprietor.
  • Do not maintain inventory (though it may still be allowable for tax purposes).
  • Prefer a simpler approach to accounting.
  • Have annual gross receipts below the IRS threshold.

This method provides an easy-to-understand snapshot of your cash flow, making it a practical choice for smaller businesses with straightforward financial needs.

Cash vs Accrual Accounting: Key Differences

  • Timing – Cash accounting records transactions when cash moves. Accrual accounting records when transactions occur, regardless of cash flow.
  • Complexity – Cash is simpler. Accrual requires more detailed records and tracking.
  • Financial Insight – Accrual provides a more accurate picture of your financial health over time. Cash accounting shows your immediate cash position.
  • Tax Implications – Each method can affect how and when you pay taxes. Accrual may lead to paying taxes on income not yet received.

A Real World Example

Imagine you own a consulting firm. In December, you complete a $10,000 project, but the payment isn’t received until January.

  • Cash Method: Record the $10,000 income in January. If your fiscal year ends in December, this defers taxes to the following year.
  • Accrual Method: Record the $10,000 income in December. Taxes are paid in the current year.

If you incurred $5,000 in December expenses related to this project:

  • Cash Method: December shows a $5,000 loss. January reflects a $10,000 profit.
  • Accrual Method: December shows a $5,000 profit. January has no related transactions.

Tax Considerations for Each Method

  • Cash Method – You pay taxes on income only when you receive it. This can help manage tax liabilities by controlling the timing of income and expenses. If you expect higher income next year, you might accelerate expenses in the current year to reduce taxable income this year.
  • Accrual Method – You pay taxes on income when earned, even if you haven’t received the cash yet. This can result in paying taxes on money not yet in hand, potentially straining cash flow now, but easing it in the future.

Considerations for Small Businesses

Ensure you’re using an accounting method that complies with IRS requirements and GAAP standards. If you have a choice, carefully weigh how each method might support your long-term business goals and short-term decision-making needs. While it is possible to switch accounting methods, the process is time-consuming, so it’s important to select a method you can stick with for the long term.

Remember, the accrual method requires more resources to manage compared to the cash method. If the accrual method aligns better with your business’s needs, consider whether you have the capacity to effectively implement and maintain it. Also, keep in mind that once you select a method, you are generally required to stick with it for at least five years.

Can’t Decide? Consult a CPA Today

Making the right accounting choice can significantly impact your business’s success. The experienced CPAs at DHJJ are here to help you navigate these decisions and tailor a solution to fit your unique needs. Contact us today to get expert advice that supports your financial goals and positions your business for long-term growth.

Print Friendly, PDF & Email

Contact

Start a
conversation

Have questions? Want to learn more about how DHJJ Fractional CFO Services can help you and your business? We’d be happy to discuss your situation.

Or call us:
630 420 1360

Print Friendly, PDF & Email