When you’re setting up your accounting system, one of the choices you’ll have to make is whether you’ll use cash basis or accrual basis accounting.The basic difference in the two approaches is the timing of when you record a transaction. The option you choose will depend on the size and type of business you have. Usually this choice is up to the business owner.
However, if your business has inventory, you are required by the IRS to use the accrual method. Inventory includes both items you have for resale and materials you stock that will become part of something you’ll sell. If you are using a computerized accounting system, you’ll set the default to one system or the other and the software will calculate your balances and reports accordingly.
Cash Basis Accounting
Cash basis doesn’t have anything to do with how you are paid. You can receive payments in cash, by check or by credit card. Similarly you can pay your bills by whichever means suits you.
In this method, transactions are accounted for at the point the money is actually received or spent. You record income when you receive the payment from your customer and you record the expense when you cut the check or charge it on a credit card.
This is similar to the way most people handle their personal finances.
Accrual Basis Accounting
In this method, you record the income when the product or service occurs, regardless of when you actually receive payment. Expenses are booked when the obligation is incurred rather than when you actually pay the vendor’s bill.
Which Choice is Best for Your Business?
The distinction between the two systems seems simple, but there are very different outcomes from a business planning and taxation standpoint. You need to balance your management needs with the tax consequences of your choice.
The cash based method gives you a very accurate picture of your business’ cash position. It doesn’t account for sales you’ve made but haven’t received payment for or unpaid expenses. Therefore, cash basis leaves a few things to be desired from a business management standpoint because it may give you a misleading profit/loss picture.
Conversely, the accrual basis method gives you an accurate picture of how the business is doing, but you might end up with a taxable profit when you haven’t actually received the money or be caught short for cash flow because you haven’t collected your receivables yet.
Many small businesses and sole proprietorships run on a cash basis. For larger businesses or those with inventory, using the accrual method generally gives you better control over the business’ finances, but you need to keep a close eye on your cash flow as well. There isn’t any one right answer as it depends on a number of factors.
Talk with your tax professional before you choose, as they will be able to advise you on which method would work best for your particular type of business. While it is possible to change your decision at a later date, to do so requires permission from the IRS, which you may or may not receive depending on the circumstances.