Cash Basis vs. Accrual Basis Accounting
These two methods provide guidelines on how you will need to record transactions and how to apply income tax. You can change which method you use after you open your business, but you will only be able to change it at the start of a new year. Now let’s get into what these two methods are.
Cash Basis Accounting
This is the simpler of the two methods. It’s similar to how you may keep track of your own finances. You account for cash when it’s received and expenses when they’re paid for.
For example, if you send out an invoice for a client project in July, but don’t receive payment until August, you record the revenue for August. This also applies to income tax and deductions. If you get billed in December 2020 but don’t pay until January 2021, the tax deduction applies to 2021.
Since your books are always updated to show what cash you have on hand, this method does not recognize accounts payable or accounts receivable. Therefore, it gives you a good look at your day-to-day finances, but it doesn’t provide information about income for a given period.
Accrual Basis Accounting
This method records transactions when the revenue is earned and expenses when they are incurred, which is the opposite of cash basis accounting.
If we use the example from above, the invoice sent out in July will be accounted for in July, even if you received the money for it in August. Taxes work in a similar fashion. Bills received in December 2020 will be deducted from your 2020 taxes, regardless if you pay it in 2021. One consideration with taxes is that if you have unpaid invoices, you’re still responsible for paying taxes on that income.
Using this method gives you a bigger picture of your income and expenses for a period of time. This gives you the opportunity to see which periods were busy and which ones were slower, allowing you to adjust how you do business.
What Method Should I Use for My Business?
You are required to use the accrual basis method if you are a corporation (excluding S-corps) that grosses more than $25 million in a tax year. Otherwise, it is your choice as to what method you want to use. Many small businesses without inventory use the cash basis method because it is easier. However, the accrual basis method helps you plan for the future since you get a better idea of cash flow for a given period.
The method that may be best for your business varies based on your business activities. If you’re trying to decide which is best for you, we recommend you speak with your accountant or bookkeeper. If you’re looking for a bookkeeper to help record your business transactions, our bookkeepers are happy to help! Please feel free to contact us or give us a call at (360) 756-5020.
For more information on accounting methods, check out the IRS Publication 538: Accounting Periods and Methods.