When starting a business and filing the appropriate tax paperwork, you will be asked what accounting basis you use for your records, and you typically have two options: Accrual or Cash. But what is the difference? And which one should you choose? Keep reading—we’ll help you make that decision.
Cash Basis Accounting
Cash basis accounting is the simpler of the two, and for most business owners, it’s the easiest to understand. Under this method, you record transactions when cash moves in or out of your business (hence the name).
Let’s go through an example. Suppose you start a business in December and need liability insurance. You find an insurance provider, and the premium is $600 for a 12-month plan. You pay the premium and record the transaction. There are two things to track: the cash payment and the insurance expense. That’s all there is to it.
Next, you get your first client and charge $250 for the services you provide immediately. When you receive payment, you record the cash inflow and the revenue (also referred to as sales).
If this is all that happens in your first year, your income statement would look like this:
Revenue $250
Insurance Expense ($600)
Net Loss ($350)
For the year, you would recognize a net loss of $350. Let see how this changes for accrual basis accounting.
Accrual Basis Accounting
Accrual basis accounting operates on a different rule—you record transactions when services are provided or when an expense is incurred, regardless of when cash moves.
Using the same example as before, you purchase a 12-month insurance plan for $600 in December and pay the premium. However, under accrual accounting, this is considered a prepaid asset—you’ve paid for a service in advance. You'll record the cash outflow and also log the $600 as a prepaid expense.
At the end of December, you have incurred 1/12 of the insurance expense, or $50. You then adjust your books by decreasing the prepaid asset by $50 and increasing your insurance expense. This is because one month’s worth of insurance has been "used," so it becomes an expense.
For the $250 in services provided, the recording process is the same as under cash basis. But let’s look at your income statement under accrual basis accounting:
Revenue $250
Insurance Expense ($50)
Net Income $200
Now, you would recognize net income of $200 for the year. For some (especially large businesses), this makes more sense because the expenses better align with the revenues earned.
Although you paid $600 for the insurance, only $50 is considered an expense because you’ve only benefited from one month of coverage. The rest remains as a prepaid asset. But which method is right for your business?
Which One is Best?
To simplify:
Small businesses: Cash basis accounting likely works best.
Medium to large businesses: Accrual basis is usually the better choice.
Some companies, particularly larger public ones, are required to use accrual basis accounting.
For small businesses, cash basis accounting is often the better option because:
It’s easier to understand.
Your tax liability matches up with your cash inflows and outflows.
For example, under accrual accounting, you’d owe taxes on the $200 net income you earned. But as a small business owner who started with $1,000, you only have $650 in cash left after paying the insurance premium. Being taxed on income that hasn’t yet resulted in significant cash flow can be tough when starting out. There are other critical expenses to prioritize.
Choosing between cash basis and accrual basis accounting is a significant decision that can impact how you manage your finances and understand your business's health. For many small businesses, the cash basis method offers simplicity and aligns with cash flow, making it easier to handle day-to-day operations. However, as your business grows or if you need a clearer picture of profitability, the accrual method can provide the financial insights necessary to plan for the future.
No two businesses are the same, so it’s crucial to consider factors such as your company's size, complexity, and growth ambitions when making this choice. If you’re unsure which method is right for you, consulting with a CPA can help ensure your business's financial records are set up for success from the start.
Ready to make the best decision for your business's financial future? Contact us today for personalized advice and support!
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