Deciding whether to keep accounting records on a cash or an accrual basis depends on your type of business, plans for its future size, and accountability to third parties, such as lenders and shareholders. So which method is right for your business?
Accrual accounting is more widely used and is the basis for generally accepted accounting principals, or GAAP, serving businesses of all sizes and complexities. Cash-based accounting is often used by business owners who have no employees or inventory.
A cash-based system may seem easier to maintain because all accounting events are tracked by the flow of cash in and out of the business. It’s essentially a checkbook. When an expense is paid, it is recorded. Similarly, income is not recorded until it is actually received, which offers tax advantages by pushing off end-of-year income to the follow year. Businesses with average gross receipts of $5 million or less that are not corporations and do not carry inventory can use the cash method.
Keep in mind that changing the method of accounting requires Internal Revenue Service approval. In many instances a request filed on Form 3115 can be granted automatically; however, the application is a complicated eight-page form. Filing for an accounting change is required even if it’s because the business has outgrown an earlier size exemption.
Accrual systems measure income when it is earned and expenses when they are incurred without regard to the receipt or disbursement of payments. If you have near-term plans to grow past $1 million in annual gross receipts, you should use the accrual accounting method from the start. Making this decision upfront permits your company to start out with the correct policies and procedures for recordkeeping and to avoid IRS charges down the road if you apply for a change.
Accrual accounting is also a better choice for a small company or organization that plans to raise capital from banks, shareholders, foundations, and other external financing sources that will likely require an audit or review by an independent accountant. An accrual-based system is necessary to create GAAP financial statements on which an auditor can express an opinion.
A business with the option to use a cash-based system may still want to use an accrual method because of other inherent differences in what the two systems provide. With the cash method, the values of long-lived assets and liabilities flow through without matching their benefits with future periods through depreciation and amortization. Business owners using cash systems add recordkeeping time with separate lists to capture noncash items such as receivables, payables, and depreciation of fixed assets.
Some of the greatest differences in the two systems show up in reporting inventory, which is why the IRS insists on accrual recognition of inventories even when it permits a business to use a cash-based system for everything else. In a true cash-based system, the entire cost of buying inventory would come in one period that could be many months, or even years, away from when its sale produces revenue. Because the timing of the revenue receipt is not matched with that of the cost of goods sold, it’s difficult to determine whether the ultimate sale produced a gain or a loss for the company. In the near term, the company would have significant tax losses that become overstated when the inventory is purchased.
Keeping cash-based records is better than having none at all, but it will not give a growing business the kind of disciplined, reliable information it needs to develop strategies and manage resources. The only thing a cash-based system truly reports is how much cash is left, but it misses much of the explanation of how and when it was obtained or spent.