If you’re a CFO or business owner, then you’ll likely need to decide between the cash or accrual accounting method for your business. There are multiple advantages and disadvantages to each, depending on the size of your business and the industry you operate in. Before choosing the cash or accrual accounting method for your business, it helps to understand a little about each one and the possible implications it can have on your company.
For instance, each recognizes revenue and affects your taxes differently. Basically, each method is a different way to record financial transactions for your business. The complexities and intricacies of both methods will affect a business differently. Here’s what you need to know before choosing between the cash or accrual accounting method for your business transactions.
Differences Between the Methods
When choosing between the cash or accrual accounting method for your business, you must first understand how each method paints a different picture of the company’s cash flow. To do that, you must understand the differences between the two methods.
The accrual method of accounting is required for larger businesses with gross revenue of over $25 million annually because their financial transactions are more complex. Smaller businesses can choose between the cash or accrual accounting method.
The cash method of accounting provides a snapshot of the business’s current revenue streams while the accrual method offers a more accurate picture of a company’s financial obligations and incoming revenue. The cash method recognizes revenue and expenses when they are paid out while the accrual method recognizes them when they are incurred. Recognizing the differences between the cash or accrual accounting method can help keep your business in compliance as you record financial transactions.
Examples of Cash or Accrual Accounting Methods
Let’s look at an example to illustrate the differences between the cash and accrual accounting methods for a small remodeling company. The remodeling company sent a customer an invoice for $20,000 for a small addition which was completed that month. The company also received invoices totaling $5,000 from contractors who helped complete the job. The remodeling company also paid out $500 in bills that were received the prior month and they also received a $5,000 payment from another client who was invoiced the prior month.
- Cash Method – Monthly profit was $4,500 ($5,000 payment received – $500 in bills paid)
- Accrual Method – Monthly profit was $15,000 ($20,000 invoice sent – $5,000 invoice received)
Each method paints a very different financial picture of the same company. While the cash method is simpler, the accrual method paints a more accurate picture. Keep this in mind when choosing between the cash or accrual accounting method for your business.
It is also important to note that once an accounting method is chosen, it can be difficult to change. While it is possible, it also requires several steps including filing the proper paperwork with the Internal Revenue Service and changing the books.
Choosing the Cash or Accrual Accounting Method
Choosing the cash or accrual accounting method is an important decision for your business. While changes can be made, it isn’t easy or always practical. Sometimes it helps to speak with a client accounting services team to determine which method is right for your business. Be sure to consider the tax implications, the size of your business, and the industry you operate in before making your decision. Once your research is done, you can choose between the cash or accrual accounting method for your business.