If your sales are more than $5 million, if you carry an inventory greater than $1 million, or if you’re incorporated, you’re using accrual basis accounting — and you don’t have a choice. But if you’re under the $5 million/$1 million threshold, you can use either the cash or accrual method. So which is best?
I’ll begin with basic definitions. In cash basis accounting, you record revenue when you get paid — when the check arrives, e.g. — and you record expenses when you write a check. In the accrual method, you recognize revenue when the sale occurs, even if you don’t get paid for several months, and you recognize expenses when they’re incurred (like when supplies are delivered at the loading dock), not when you write the check to the vendor. Each method has its pros and cons.
The cash method is simple. For each sale and each payment, there’s only one transaction. It also gives you an accurate picture of where you stand at the moment. It will, for example, tell you if there’s enough money in the business to pay yourself a bonus. Another advantage is the flexibility cash basis accounting gives you, particularly if you’re small. For example, you can choose to deposit a check on January 1 instead of December 30, and thereby defer taxes on that sum for a year. Also, you could decide to pay some invoices early, so that your taxable income for the current year will be less.
The problem with cash basis accounting is that it can give you an unrealistic view of how you’re really doing.
Say, for example, that you’re in the kitchen remodeling business, and you get a $20,000 project. You order $8,000 worth of lumber, appliances, etc., on credit. You start the job on March 1 and get $5,000 upfront. With cash basis accounting, on March 31 it looks like you made $5,000, when in fact, you “lost” $3,000. The invoice for the materials just hasn’t arrived. This is an oversimplification, and you would of course remember that a big bill was on its way. But if you’re running multiple projects, or have large numbers of small transactions that you can’t keep track of in your head, then cash basis accounting can distort reality.
Accrual-based accounting involves twice as many entries. For instance one when you recognize the revenue and one when you actually get paid, so it’s a little bit more work. But it does give you a clear picture of where you really stand. In the case of the $20,000 kitchen remodeling job, accrual-based accounting would record the revenue when the contract was signed, and the cost of materials the day they arrived. It would also record the cost of contract labor at the time you signed the contract (assuming you’re that formal). So you would know what your true profit picture was in advance. Again, with multiple transactions, this can become important.
In my experience, the biggest problem with accrual-based accounting is the temptation to recognize revenue earlier than you should. If you have sales people on commission, they want revenue recognized as soon as possible. And you yourself may occasionally be tempted to speed up revenue recognition to improve how the books appear. (Don’t!)
To state the obvious, the choice between cash and accrual depends on your particular situation. But you should know that you have a choice.