While the accrual basis of accounting provides a better long-term view of your finances, the cash method gives you a better picture of the funds in your bank account. This is because the accrual method accounts for money that’s yet to come in.
Cash basis accounting
The cash basis of accounting recognizes revenues when cash is received, and expenses when they are paid. This method does not recognize accounts receivable or accounts payable.
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.
Which one is better for your business?
Under these guidelines, all companies with sales of over $25 million must use the accrual method when bookkeeping and reporting their financial performance.
Unless your company makes more than $25 million in gross annual sales, you’re free to adopt whichever method makes more sense for you.
However, keep in mind that the IRS requires companies to use and maintain the same accounting method to report taxable income for a year — so no changing halfway through the tax year.