As a business owner, managing the finances of your fast-growing company can be a hassle.
Choosing a suitable accounting method for your business is one of the most crucial early decisions you'll make. Remember that once you choose between the cash or accrual accounting methods (the two most popular methods), you can't reverse it—the IRS mandates that you continue with your choice for the rest of the tax year based on GAAP regulations.
It's a high-stakes decision and there's no room for error. A careful analysis of the pros and cons of both options will help you select the accounting method that best meets your company's needs.
We're here to help you choose the right accounting strategy to provide accurate insight into the financial health of your business.
Continue reading to familiarize yourself with the cash vs. accrual accounting debate and make an empowered decision that steers your business on the right path.
What is the difference between cash vs. accrual accounting?
The primary difference between cash and accrual accounting lies in the timing of recording expenses and revenues.
- In cash-based accounting, revenues are reported on the account statement only when cash is received from the client. Similarly, expenses are recorded only when money is paid out, irrespective of when goods or services are purchased.
- In accrual accounting, revenues are recorded as soon as the product or service is delivered, with the expectation that the customer will pay soon. In simple terms, revenues are reported before the cash arrives. Expenses for goods and services are also recorded immediately when the bill is incurred, irrespective of when the money is paid out.
Let's take a closer look at each of these accounting methods with examples.
A brief overview of accrual-based accounting
Accrual basis accounting is a method of bookkeeping in which revenues and expenses are recorded as soon as they are incurred, regardless of when the money is received or paid. The following is an example of what this looks like:
Let's say you deliver a shipment to a client in July and the client pays you 60 days after the invoice is raised. In accrual accounting, revenue is recorded in July, even though you don't receive the payment until September.
The upside of accrual accounting is that it gives you a more realistic picture of the financial health of your business because it tracks all income and expenses. This offers long-term insight into your business operations.
The downside is that it doesn't reflect the actual cash flow of the business. This means your business might appear to be doing well even when your bank accounts are empty, and vice-versa. Accrual accounting without real-time expense tracking can cause devastating consequences.
A brief overview of cash-based accounting
Cash basis accounting systems document incoming revenues when cash is obtained and expenses when money is disbursed. It does not take into account accounts receivable and payable.
Using the example above, you deliver a shipment to a client in July and the client pays you in September. In cash-basis accounting, the revenue is recorded only in September when you receive payment from the client, even though you delivered the product in July.
The upside of cash accounting is that it provides you with an accurate picture of the cash flow of your business. You can look at the cash flow statement and see the cash at your disposal. The downside is that it doesn't match revenue with expenses and can provide a distorted view ofthe overall financial health of the business. It provides an overview of cash received and cash paid during the period although cash is earned and expenses are incurred.
Cash basis vs. accrual basis accounting: Advantages and disadvantages
Both of these methods have benefits and limitations. Understanding them can help you make the right decision.
Advantages of the cash method
- Easy to use: The cash method is easy to understand, even if you have no prior experience handling the finances of a business. Here, you simply record transactions when you pay or receive cash. All you need is accounting software for small businesses, and you're good to go.
- Offers a clear picture of the cash flow: Cash accounting makes it easy to manage your business your business cash flow. This way, you'll know exactly how much cash your business has on hand.
- Can help lower your taxes: Let's say your fiscal year ends in December 2022. You raise an invoice to a customer in December but won't receive payment until January 2023. With cash accounting, this invoice will be part of your taxable income for 2023, reducing your tax liabilities for 2022.
Disadvantages of the cash method
- Limited insight: Cash accounting provides a snapshot of your company's transactions at a particular point in time. It doesn't take into account liabilities and receivables, making it difficult to get the complete picture of your financial health.
- Not suitable for all businesses: Cash accounting is not applicable for your business if you offer credit to customers or maintain product inventory. Also, if your gross receipts cross the $25 million threshold, you have to use accrual accounting.
Advantages of the accrual method
- Accurate and versatile: The accrual method provides you with an accurate picture of your company's financial health. It includes receivables and liabilities, match revenues with expenses, helping you monitor your company's true profitability.
- Scalable and future-proof: Eventually, most businesses convert from cash-based accounting to accrual accounting as their business grows and investors require more in-depth performance reports. Switching from cash to accrual can be cumbersome. Starting with accrual accounting from the outset helps you avoid this challenge down the line.
Disadvantages of the accrual method
- Slightly more complex: You have to track multiple accounts, such as unearned revenue, accounts payable, receivables, and liabilities. You can overcome these challenges with the right accounting solution.
- Difficult to track cash flow: The accrual method doesn't provide an accurate picture of the cash flow of your business. For example, the income statement might show thousands of dollars in revenue from sales. However, you might not receive the cash for a few months, until the customer clears the invoice. You can overcome this inefficiency by using a monthly cash flow statement to accurately depict the money flowing in and out of your business.
How to choose the right accounting method for your business
The differences between cash and accrual-based accounting often depend on the size of your business and its average annual revenues. Generally, small businesses prefer cash accounting as it's easier to understand and maintain. Although accrual accounting doesn't provide you with an accurate picture of cash flow, it helps you get a clear idea of expenses and income for that particular time.
So, which one should you choose? Here's a quick overview of choosing accounting methods based on IRS rules:
The IRS states that you cannot use the cash method if your business is:
- A corporation with average yearly gross receipts for the last 3 tax years exceeding $25 million (The IRS exempts S corporations from this rule).
- A partnership with a corporate partner and average yearly gross receipts for the last 3 tax years exceeding $25 million
- A tax shelter as per Section 448(d)(3)
So, if your business is a corporation (other than an S corp) with gross receipts of less than $25 million per year, you can consider cash accounting. That said, cash accounting is better suited for businesses that don't carry inventory. Accrual accounting might be the better choice if your business handles extensive inventories.
Simplify expense tracking and cash management with Ramp
No matter the accounting method you choose for your business, we can help. Ramp makes it easy to keep track of your business expenses, giving you clear insight into your finances and more control over cash management. You'll know exactly how much money your business earns and how much goes out. Empowered with this information, you can choose the best accounting method (cash or accrual) for your business requirements, both today and in the future.
We're here to eliminate the guesswork of managing your company's finances. Our unique approach to innovative financial solutions has made us one of the fastest-growing financial companies in the US. Companies that use Ramp save an average of 3.3% in their operating expenses in the first year and close their books faster.
