Cash Versus Accrual Accounting for Small Businesses

Learn which of the two generally accepted accounting methods is right for your small business

There are only two generally accepted accounting methods: cash and accrual accounting. Some small businesses have the option of choosing between these two, while other kinds are legally required to use the accrual method. This article explains the conditions under which a small business has to adopt the accrual accounting method, and discusses the benefits of the cash method in circumstances that allow a business to choose it.

Definitions

Cash Accounting: The cash system records accounting events when they become tangible: e.g., when a customer's check arrives, when a shipped product reaches the customer, or when money for a business-related expense is removed from the bank. Cash accounting registers income when money arrives and registers expenses when money goes out the door. The cash accounting method is more familiar to most people because it's what most individuals use in tracking their personal finances. Under this method, one's income is taxable when it's received, and expenses are deductible when they're paid. Cash accounting is a straightforward and easily understood method of record-keeping for tax purposes.

Accrual Accounting: The accrual accounting method approaches accounting events in real time. When a customer signs a purchase order, the accrual system registers it as a sale - even though it may be weeks or months before you receive the full payment. Similarly, when you enter into an arrangement in which you will be paying for goods or services, the accrual system doesn't wait until you've actually paid out the money to record it as an expense. This option should help present a more accurate picture of a business' condition, yet the complexity of this method (which usually requires the aid of a finance professional to implement) also can result in an enterprise owing taxes on income it has yet to receive, which can be a serious hassle for new or small businesses that aren't flush with cash.

When is Either System Mandated By the IRS?

Cash Accounting: Cash accounting is never mandated by the IRS. In other words, there is no tax-related scenario that forces you to adopt cash accounting. However, as you'll see, sometimes you can't choose it even if you want to.

Accrual Accounting: Accrual accounting is the system you must use if:

1. You have more than $10 million in annual gross receipts.
2. Your gross annual receipts are less than $10 million but over $1 million and your primary business activity can be classified as wholesale, retail, publishing, sound recording or mining.
3. You are a partnership or tax shelter.
4. You are a farming corporation that meets certain IRS rules listed in Publication 225.

Point No. 2 can be tricky and requires further explanation, especially now that the IRS has become more lenient in letting certain small businesses remain with the cash system. If your annual gross receipts are between $1 million and $10 million, the IRS generally lets you use the cash accounting method for your principal enterprise across all of your businesses. For example, you run both a plumbing service and a retail plumbing store. Last year, you made $1.2 million from the service and $500,000 from the store. In this case, the principal activity is the service, not the store. So if you find the cash system more convenient for the service, you can extend it to the store. However, if this year the store will make $2 million, and the service will drop to $1 million. Because the store has become your principal business and falls under the retail category, the IRS wants you to move to accrual for at least the store. At this point, it may become so much of a headache to keep separate systems for the store and the service that you'll probably adopt accrual for both.

When Should You Choose Either System?

Cash Accounting:

1. When your annual gross receipts are less than $1 million. In this case, your business may not be complex enough to warrant the added sophistication of accrual accounting.
2. If your primary business is service-related and also in the $1 million gross annual receipts range. Your business may be simple enough to allow you to adopt the easier cash system of accounting.

Accrual Accounting:

1. When your annual gross receipts are more than $1 million and your business is complex - for example, payment cycles are longer, you have many revenue streams or you maintain a large inventory of products.
2. You want better insight into your business' fiscal standing. In this case, you're willing to put the extra effort into accrual accounting so you can get a real-time snapshot of your financial health.

The Good News About Accrual Accounting

Ideally, all small-business owners would opt for an accounting method that showed their companies' real-time financial health. That's what makes the accrual method so valuable. However, until now, the complexity of accrual has dissuaded many small companies from adopting it. The good news is that most accounting software packages simplify the process of accrual accounting. Moving from the cash system to accrual can be as easy as checking a box in your accounting software, which will do the rest for you.

That said, if you run a simple and low-revenue business, don't feel pressured to adopt the accrual system.