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Cash or accrual--how do you choose? Each method has its pros and cons, and picking one really depends on your needs and the needs of your business. The most important question to ask yourself is, what do I need to know from my accounting system? The answer to this question will determine whether you should go with the cash method or opt for the generally more expensive and time-consuming accrual method.
If it's just about taxes, go with cash
Most professionals and small businesses do the books for one important reason: taxes. If not for taxes, many owners would probably not bother to keep records--it's enough for them just to watch the bank balance go up or down each month to get an idea of how the business is doing. If this sounds like you, the cash method is the way to go. With the cash method, you only count income when it is received, and expenses when you pay your bills. This is how most of us intuitively think about accounting, and it is completely acceptable for tax purposes for individuals and most small businesses. Keeping your books on a cash basis is actually better for tax purposes, since you won't have to convert from accrual basis at the end of the year.
Want better info? Accrual may be for you
While cash basis accounting is totally acceptable for tax purposes for most small businesses, it can have some big disadvantages when it comes to managing your enterprise. The biggest one is that income and expenses aren't matched up from month to month.
As an example, let's say you are a contractor and do a kitchen remodel in March. You have no other work for the month. During the month you get paid $50,000 and spend $20,000 on materials. You also hire your brother, Paul, as a subcontractor for $10,000, but you don't have to pay him until April. On a cash basis, the books will show a profit of $30,000 ($50,000 - $20,000), but if you go out and spend that much you'll be in trouble with Paul! You still owe him $10,000. Your true profit for the month is $20,000 ($50,000 - $20,000 - $10,000).
Imagine now the same situation except that you have negotiated with the client to be paid 50% in March and the remaining 50% in April. In March, on a cash basis you would show $25,000 in income and $20,000 in expenses for a profit of $5,000. In April you would have income of $25,000 and $10,000 in expenses for a profit of $15,000--but you didn't actually do any work in April.
It is easy to keep track of money owed to you and others--as well as profitability--if you only have a few clients at a time, but imagine trying to keep track of it when you have 50 or 100 clients. Accrual basis books take care of this problem by matching income and expenses in the proper month, regardless of when the money comes in or goes out of your bank account. If you have a business with many customers, sporadic levels of activity, and accounts receivable and payable, accrual basis will give a much better idea of how profitable you are than cash basis.
The time factor
Before jumping in and setting up an accrual basis accounting system, ask yourself the following questions:
- How much time am I willing to give up to do the books each week?
- How much money am I willing to spend?
Probably the biggest barrier for most people in setting up accrual basis books is the time factor. Doing accrual books the right way takes time. It means creating invoices for every sale and entering bills as they arrive in the mail. These tasks should be performed at least once a week--budget one afternoon. Then the books need to be reconciled with the bank statements once a month.
For those who can afford a trained employee or assistant (or professional bookkeeper), this isn't a problem, but most people doing it themselves don't make the time, especially if they are busy sole proprietors. Software such as QuickBooks makes this a ton easier than it used to be, but data entry still takes time, and the software is admittedly not the easiest to use--that's why we have a ProAdvisor program.
The money factor
Good accrual accounting software usually costs money, whether you opt for desktop software or a monthly subscription. The most common desktop version of QuickBooks is $133 on Amazon and a monthly subscription to QuickBooks Online Essentials goes for $26.95. You can use QuickBooks for cash or accrual accounting, and one big benefit is that you can switch from one to the other.
However, if you work for yourself and just want to track finances on a cash basis, you can sign up for Mint.com for free. Mint is designed for individuals, but lets you add your own subcategories for business income and expenses, making it a great option for professional freelancers. After using accrual software for my own business for a year, I made the switch to a separate invoicing system in combination with Mint.com and haven't looked back.
All of these apps will automatically download transactions from your bank account. I consider this feature to be a requirement these days for any accounting system, given how much time it saves.
In summary
Cash basis
What is it?
- Income = money in, expenses = money out
Who can use it for taxes?
- Individuals
- Professional services
- Farming businesses
Pros
- More intuitive
- Easier. Categorize transactions as they download from the bank website, or just enter them manually from the bank statement
- Less expensive. Mint.com is free
- Most tax returns are filed on a cash basis, so no need to convert from accrual
Cons
- Reports are not as useful for management purposes since income and expenses may not match up, especially if you incur a lot of expenses to generate revenues
Accrual basis
What is it?
- Income is matched to expenses, regardless of when cash is received or bills are paid
Who is required to use it for taxes?
- Businesses that carry inventories with gross receipts >; $1 million
- Corporations that are not S corporations
- Partnerships with a corporate partner
- Tax shelters
Pros
- Matching of income and expenses produces more useful reports that help you get a better idea of how profitable your business really is
Cons
- Less intuitive. You may need a professional to help you understand the reports
- More time-consuming. Must enter transactions before they hit the bank statement
- Potentially more expensive, although software has come down in price significantly in recent years, and now you can pay a monthly subscription
The Bottom Line
The big difference between cash and accrual accounting is the amount of time you will have to put into it. Cash basis takes less time and software is available for free. Accrual takes more time and you will probably have to pay for good software.
As with any business decision, the cost of an accounting system should never exceed the benefit. If you already have a good idea of how profitable your business is (and you are allowed to use cash basis for tax purposes) the cash method will probably serve your needs just fine. If you are looking for ways to improve profitability and want to know in more detail where the money is flowing, accrual accounting can help.
