Are You Using the Right Accounting Method for Your Business?

Two Popular Methods

Out of a variety of available accounting methods, the two most popular are:

1. Cash-basis accounting

Under this method, your business records income as cash is received. For instance, if you bill a customer in March but don’t receive payment until April, you’d record the sale in April.

Similarly, cash-basis businesses record expenses as they’re paid, regardless of when they’re incurred. So, if you receive a bill from a vendor in March with net 30 terms and pay in April, you’d record the expense in April.

2. Accrual-basis accounting

The accrual method “matches” revenue with the related expenses by recording revenue when it’s earned and expenses when they’re incurred. For example, if you bill a customer in March but don’t receive payment until April, you’d record the sale in March (a month earlier than under cash-basis accounting). For financial reporting purposes, revenue recognition isn’t tied to when you receive a payment from the customer.

Likewise, if you missed your March rent payment of $5,000 and pay double the amount in April, you’d still record $5,000 of rent expense in both March and April. The missed payment would appear on the balance sheet as an accrued expense (a liability) in March.

Cash: Pros and Cons

Both methods come with advantages and disadvantages. Cash-basis accounting simplifies recordkeeping and has a short learning curve. It mirrors your cash flow and short-term financial health, making it easy to assess your cash position and how it fluctuates over the year.

While cash-basis accounting offers simplicity, it can also paint a distorted picture of your company’s operations. This method’s vulnerability to manipulation can be exploited by unscrupulous individuals seeking to misrepresent financial statements for personal gain. For example, a manager incentivized by year-end earnings might deliberately delay cashing checks to inflate cash-basis profits for the current period. Or, when a retiring partner’s buyout is based on a multiple of the previous year’s earnings, remaining partners might postpone depositing a significant customer payment at year-end to artificially reduce cash-basis profits and lower the buyout amount. Because cash-basis accounting doesn’t properly match revenue and expenses to the periods in which they’re earned and incurred, it can be hard to compare a company’s performance over time under this method.

In addition, a cash-basis balance sheet doesn’t show certain familiar line items, such as:

• Accounts receivable,
• Accounts payable,
• Work-in-progress (WIP) inventory,
• Prepaid assets and
• Accrued expenses.

This can make it difficult to evaluate a company’s working capital needs. Cash-basis accounting also doesn’t conform with U.S. Generally Accepted Accounting Principles (GAAP), so external comparisons with public and private companies may not necessarily be meaningful.

Accrual: Pros and Cons

By aligning revenue and expense recognition with the periods in which they are earned and incurred, accrual-basis accounting provides a more precise and comprehensive picture of a company’s financial health, enabling more-informed business decisions. This method is mandated for publicly traded companies under GAAP and is generally favored by stakeholders, such as lenders and investors.

But accrual-basis accounting is generally more burdensome. Booking revenue and expenses requires multiple journal entries. For example, an accrual-basis business will record revenue and a receivable (an asset) when products are delivered or services are rendered. Then it removes the receivable from the books when the customer pays the invoice. (The receivable might also be removed from the balance sheet if product is returned or an uncollectible balance is written off.)

Likewise, expenses must be recorded as incurred, regardless of when they’re paid. Tracking expenses under the accrual method results in the creation of various balance sheet accounts, such as WIP, prepaid assets, accruals and payables.

A Tough Decision

For sole proprietorships and other small businesses in the early stages of development—particularly those without product inventory—cash-basis accounting offers a straightforward and manageable approach to financial recordkeeping. This method typically requires minimal time commitment and can often be implemented without the need for professional accounting assistance.

Cash-basis accounting also provides tax planning opportunities. For example, if you expect your tax rates to be the same (or lower) next year, you could hold off on billing and accelerate paying expenses at year end to lower taxable income in the current tax year and defer some of your tax obligation until next year. Conversely, if you expect tax rates to be higher next year, you could do the reverse: ramp up collections and wait to pay expenses after year end. This strategy would increase your taxable income for the current tax year — before tax rates go up next year.

Larger, more complex businesses generally opt for accrual-basis accounting. Not only do lenders and investors generally prefer GAAP financials, federal or state tax law may require accrual-basis accounting. Under current tax law, for 2023, a business that produces, purchases or sells merchandise generally must use the accrual method for sales and purchases of merchandise if it has average gross receipts of more than $29 million over a three-year period (up from $27 million for 2022). This threshold is indexed annually for inflation.

In certain states, sales tax returns must adhere to accrual-basis accounting, necessitating meticulous tracking and planning to avoid unexpected sales tax liabilities on uncollected payments. Unanticipated expenses can choke your cash flow.

Time for a Change?

Once you’ve submitted your initial federal tax return for your business, switching from cash to accrual accounting or vice versa typically necessitates IRS approval. Collaborate with your tax advisor to identify the most suitable accounting method for your current situation and ensure the proper forms are filed.