If you’re like most small business owners, you probably haven’t put much thought into accounting methods. You may or may not even be aware that you have options when deciding how to do your accounting and that your choices will impact how you produce your financial statements and file your taxes.
What is an accounting method? The term refers to the rules your business must follow when reporting revenues and expenses. The two primary accounting methods are cash accounting and accrual accounting. Hybrid accounting, as the name implies, is a mixture of cash and accrual accounting.
Public corporations in the United States must use the accrual accounting method (as most corporations average more than $26 million in total yearly revenue). However, many small businesses opt for cash accounting because of its simplicity. Before deciding which is best for your business, you should learn more about each one.
Cash accounting, sometimes called cash-basis accounting, is a method of accounting that records expenses when they are paid and revenues when they are received. Sounds simple, right? It is, and simplicity is one of the primary benefits of choosing this accounting method.
When you use cash accounting, your business will only recognize and record transactions when money changes hands. If your business makes a sale, you’ll record that transaction as revenue as soon as it hits your account. Similarly, when you pay your business’s monthly rent or utility bills, you’ll record those expenses when the money leaves your bank account.
Cash accounting is relatively easy to understand, and it’s a method that can work well for smaller businesses, particularly those that don’t have a lot of inventory. It’s also an effective method for showing you exactly how much cash your business has, which can be important information for a new business without any capital reserves.
Bookkeeping can be easier when using a cash accounting system because you can utilize single-entry bookkeeping. With single-entry bookkeeping, you only need to enter each transaction once in your bookkeeping journal or spreadsheet. This leaves you with a sequential list of all your transactions and makes it very simple to see your account balance at any time.
There are tax advantages to cash accounting as well. You’ll pay business income taxes only on the money you’ve received (as opposed to paying taxes on the invoices you’ve sent). This can help a smaller business with its cash flow.
A cash accounting method won’t give you a complete picture of your business’s long-term financial health. It doesn’t do a great job of forecasting long-term expenses and liabilities, meaning that your balance sheet may look healthy today, but it isn’t fully considering future expenses.
Additionally, cash accounting may make raising money from lenders and investors more challenging. Businesses that use the cash accounting method can show large monthly swings on their books based on when revenue payments come in, and expense payments go out. Cash accounting makes it easy to show how much your business has in the bank right now but more challenging to forecast what that balance might look like six months or a year from now, which is the type of information lenders and investors typically want to see.
In contrast, accrual accounting allows your business to recognize and record revenues and expenses before they’ve been received or paid out. When using the accrual method of accounting, your business can count something as revenue as soon as the transaction occurs, even if payment isn’t expected immediately. For example, if your company provided a service to the customer, you would count that as revenue when you issued the invoice, even if that invoice wasn’t due to be paid for 15 days. Similarly, when you incur an expense – by ordering business supplies, for example – that expense is immediately entered into the company books, even if you won’t pay for those supplies until the end of the month.
The most significant advantage of accrual accounting is that it provides a more accurate picture of your company’s financial health. It offers more flexibility than cash-basis accounting and allows you to track your revenue and expenses.
For example, imagine your business enters into a six-month service contract with a customer today, and that customer pays their entire balance due immediately. Using a cash accounting method, you would record the entirety of that payment as income for this month because that’s when you received the funds. Using accrual accounting, you can more accurately spread that revenue across the entire six months.
Similarly, accrual accounting allows you to track expenses more helpfully. If you record expenses for supplies when you order those supplies, that expense shows up on your books immediately. Whereas with cash accounting, even though you’ve already committed to spending the money, you won’t record the expense until the invoice comes due and you pay it. This means that cash accounting can make your financial bottom line look better than it is simply because you haven’t yet paid all your bills.
Another important advantage of accrual accounting is that it helps business owners forecast their future financial picture more accurately.
Complexity is the biggest disadvantage of accrual accounting. The accrual accounting method requires double-entry bookkeeping and tracking more accounts. You’ll likely need a professional bookkeeper to keep up with your financial records.
Accrual accounting also has tax implications that can be difficult for smaller businesses that don’t have cash reserves. Because revenue is recorded before it is received, your business may pay taxes on income that hasn’t yet hit your account.
Other Accounting Methods and Tax Implications
The hybrid accounting method, modified cash basis accounting, blends cash and accrual accounting. The mixed method allows smaller businesses to keep track of their short-term assets on a cash basis, which can be a more straightforward way to manage your balance sheet and understand how much cash you’ve got on hand at any given time.
Businesses that use a hybrid method could record longer-term investments using an accrual basis. For example, keep track of your inventory or equipment using the accrual method, allowing you to more accurately record their ongoing cost on your balance sheet rather than as lump-sum expenses.
For some small businesses, the hybrid method blends the best of both worlds. It combines the simplicity of cash accounting with the benefits of accrual accounting in predicting future cash flow.
As noted above, the IRS requires publicly-traded companies and those companies above certain yearly revenue thresholds to use the accrual accounting method. Smaller, privately-run businesses can choose to use cash-basis accounting, modified cash-basis accounting, or accrual accounting.
No matter which method of accounting you choose, your internal records must match. That is, if you keep track of your business finances using the accrual method, you must also file your taxes based on that method. This seems obvious, but it raises important considerations for businesses using a hybrid accounting method. The IRS requires that whichever accounting method you choose to report income must also be the method you use to report expenses. Essentially, if you’re using a hybrid accounting method, you’ll need to consistently apply your accounting methods to pass IRS muster.
Additionally, once your business has chosen an accounting method, you will need to formally request the IRS if you want to change that accounting method at any point in the future.
If you have a small business that doesn’t have a lot of inventory, using a cash-basis accounting method can certainly save you time and effort. Cash accounting makes it easier for individuals, sole proprietors, and service-based small businesses to manage their books and gives them an accurate short-term picture of how much money they have in the bank.
Growing or small businesses with a lot of inventory are likely better off choosing an accrual accounting method. You may need to hire a professional bookkeeper, but using accrual accounting will ensure that your business has room to grow and a better handle on the financial future of your business.
Having a professional to guide you in making this crucial decision can make all the difference. Remote Quality Bookkeeping has services specifically designed with small businesses in mind. Get in touch today and learn about our small business accounting services.