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Cash vs Accrual Accounting Pros & Cons

February 18, 2010

From business.gov community by ChristineL

Are you starting a small business and trying to set up an accounting and bookkeeping method?

Are you confused about how to record your business income and expenses when filing your taxes?

If you answer yes to either question, read on to learn when cash vs accrual accounting method can work better for your small business.

Cash Accounting

Cash accounting is the more popular method of recording and reporting small business income and expenses. In a cash accounting method, income and expenses are recorded only when funds are received or disbursed.

For example, you may file your business tax returns using the calendar tax year* (12 consecutive months beginning January 1 and ending December 31).  If you provide a service to a client in December 2009, but do not receive payment for those services until January 2010, you would record the income for the 2010 tax year. The same is true for an expense. If you write a check for an electricity bill in December 2009, but the check is not deducted from your bank account until January 2010, you would record the expense for the 2010 tax year.

Important Notes about Cash Accounting

  • If your business files on a fiscal year calendar, you can still use a cash accounting method. You still report your income and expenses as they occur, but depending on when the transaction took place, it may fall in a different tax year. Learn more about calendar tax year versus fiscal tax year reporting on IRS.gov.
  • You cannot delay paying tax on income by holding on to checks from one tax year to the next. You must report income when you receive it.
  • The IRS restricts certain profitable entities (grossing $5 million) from using a cash accounting method, and requires special rules for farming businesses. For restriction details read on at IRS.gov.

Pros & Cons

When you consider using cash accounting, understand the following advantages and disadvantages for your business:

  • Accurate Tracking of Cash Flow. Cash accounting gives an accurate reflection of your cash flow. Since it only records revenue and expenses when they actually appear in your account, you know how much cash you have on hand in the particular moment.
  • Inaccurate Representation of Long-Term Revenue & Expenses. While cash accounting accurately tracks cash flow, it gives a false impression of your revenue and expenses. For example, if your business generated a lot of revenue in 2009, but payment for that revenue was not received until 2010.  As a result, your business shows negative cash flow, even though you anticipate receiving payments.
  • Less Bookkeeping. Tracking your business account is fairly straightforward – transactions are recorded only when cash leaves or enters your account.

Accrual Accounting

In accrual accounting, income is recorded when a sale is made, even if you do not see payment right away. Expenses are recorded when services or goods are received, not when they are paid.

Going back to our calendar tax year example, in accrual accounting, a business that provides service to a client in December 2009 would record this transaction as 2009 income, even if it doesn’t receive payment until February 2010.

Important Notes about Accrual Accounting

  • If payment was made in advance for services to be completed in the next tax year, you can delay paying tax on that income until the next tax year. No postponement afterwards is permitted.
  • If you paid for an expense in advance, you can only deduct it in the year it to. See IRS.gov for exceptions to the rule.

 When you consider using accrual accounting, understand the following advantages and disadvantages for your business:

  • Accurate Tracking of Long-Term Revenue & Expenses. An advantage of accrual accounting is a more accurate picture of your operations. For the specified time period, you see how much business you have done and what expenses you have incurred.
  • Inaccurate Representation of Cash Flow. Accrual accounting encounters the opposite problem of that of cash accounting: inaccurate representation of your cash flow. You may have closed a lot of sales that particular year, but if your customers have not paid you, you do not have the money in your account. In other words, even though your business has generated a lot of revenue, you do not have the cash for those sales.
  • More Bookkeeping. For cash accounting, you only need to record when you make or receive a payment. For accrual accounting, you would record both the transaction date of the sale and the date of received payment. However, it can be much easier to keep track of these transactions if you use an accounting tool or software.

Hybrid Method of Accounting

The hybrid method of accounting allows your business to use any combination of cash, accrual, and special methods of accounting. Generally, the IRS allows businesses to use this method as long as it is calculated and reported consistently. However, you cannot use the hybrid method if you use cash accounting to report income or accrual accounting to report expenses. See IRS.gov for more exceptions.

So Which Accounting Method is Right for Me?

There is no “right” accounting method for all businesses. Both cash accounting and accrual accounting have their pros and cons. However, certain businesses prefer one over the other depending on the following factors:

  • Business Size. Smaller businesses like sole proprietorships and partnerships may prefer cash accounting because it’s simpler and requires less bookkeeping. Businesses often switch to accrual accounting as their businesses grow to more accurately reflect their revenue and expenses.
  • Tax Deductions. Depending on the type of business you run, cash or accrual accounting may be more beneficial when filing your taxes. If you incur expenses in December 2009, but don’t pay for them until January 2010, you can still claim tax deductions for 2009 if you use accrual accounting. On the other hand, you would not be able to claim deductions until the 2010 tax year if you use cash accounting.
  • Internal Accounting. Using the same accounting method internally and for tax purposes is a good practice because it simplifies the accounting process when calculating your income and expenses. However, the IRS does allow you to use a different method for internal accounting and tax accounting, if you decide to do so.

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One Comment leave one →
  1. May 23, 2010 9:53 pm

    Best reading for a while

    Keep up …

    Merta

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