1.04 – Tackling The Big Decision: Cash-Basis or Accrual Accounting
Deciding between cash-basis and accrual accounting is a crucial step before recording transactions. Each method offers distinct advantages and challenges, primarily revolving around how transactions are recorded.
Waiting for Funds with Cash-Basis Accounting
With cash-basis accounting, transactions are recorded when cash changes hands. This means you’ll log entries when payments are received or made, whether it’s through cash, check, credit card, or electronic transfer.
However, this method isn’t suitable for businesses that sell products on credit and bill customers later. Cash-basis accounting lacks provisions for tracking money owed by customers. Similarly, purchases on credit are only recorded once the actual payment is made.
Small businesses often start with cash-basis accounting due to its simplicity. But as a business grows, switching to accrual accounting can become necessary to more accurately track revenues and expenses.
While cash-basis accounting efficiently tracks cash flow, it struggles to match revenues with expenses. For instance, if you purchase products in June for $1,000 and sell them in July for $1,500, your June report shows a $1,000 loss, and July shows a $1,500 profit. In reality, your profit over two months is $500, but cash-basis accounting splits the transactions inaccurately.
This section focuses on accrual accounting. If you opt for cash-basis accounting, much of the bookkeeping information provided will still be useful, but you won’t need to maintain accounts like Accounts Receivable and Accounts Payable, unless you track credit sales separately.
Making the Switch to Accrual Accounting
Switching from cash-basis to accrual accounting isn’t always straightforward. It’s advisable to consult with an accountant to ensure compliance with regulations, which might include getting IRS approval. You might need to file Form 3115, the Application for Change in Accounting Method, to make this change.
Businesses that generally shouldn’t use cash-basis accounting include:
- Businesses with inventory and annual sales over $1 million
- C Corporations
- Businesses with gross annual sales over $5 million
Recording Right Away with Accrual Accounting
Accrual accounting records transactions when they occur, regardless of cash movement. Sales on credit are immediately recorded in an Accounts Receivable account, and purchases on credit are entered into an Accounts Payable account.
This method matches revenues with expenses more effectively but can make cash flow tracking challenging. Your income statement might look positive while the bank balance remains low, especially if customers delay payments.
Businesses often monitor cash flow weekly to ensure sufficient operating cash. Seasonal businesses might establish short-term credit lines to manage cash flow during off-peak periods.
Switching to accrual accounting can provide a more accurate financial picture, helping businesses make informed decisions and plan for future growth.
