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Cash or Accrual Accounting: Which Is Best for Your Business?

June 1, 2017 / by Jane Lvovskiy

Young businessman calculating.jpegBefore you can answer the question posed above, you need to understand the difference between the two types of accounting.

Essentially, cash accounting is just what it sounds like — a pay-as-you-go approach that documents your payables and receivables in real time, more or less. With accrual accounting, there's a lag between the time you receive your "accounts payable" goods or services and the time you actually pay for them; the same is true on the "accounts receivable" side of the ledger.

As long as it all comes out in the wash, does it matter which one you use? The answer often comes down to timing — and to IRS regulations.

Opt for Cash Accounting
Let's say you have a modest nail salon and follow the standard calendar tax year (Jan. 1 – Dec. 31) for your financial reporting. Most of your work consists of manicures or pedicures that cost relatively little, and your customers pay in full each time. You reorder supplies and replace equipment on a regular basis.

In this case, cash accounting is appropriate. Your cash flow is in sync with your expenses. Basically, you have what-you-see-is-what-you-get financial records and little cause for concern from the IRS's perspective. There is one caveat, however: If you stock products, like haircare, skincare or nail care products, IRS rules say you must use accrual basis accounting (more on this below).

Accrual Accounting Is Best
Now let's say that rather than operating a nail salon, you're a general contractor. Most jobs take months from start to finish and involve a large upfront investment in construction materials. You're also responsible for paying subcontractors. Generally, you receive a percentage of your fee upfront, with additional payments for hitting certain milestones and a final payment upon completing the job. Delays, such as those caused by severe winter weather, can easily push those payment milestones from one calendar year into the next.

If you still use cash accounting in this instance, your books will be out of whack. In other words, you need to record accounts payable and accounts receivable in the time period when they were charged, not when they were actually paid. (Some state licensing requirements specifically dictate that small contractors use accrual accounting. It's also an issue in the construction bonding and insurance business.)

No Mixing and Matching
At the very least, you need to be consistent with whichever method you choose. In general, you can't mix and match the cash method and the accrual method to deduct expenses in one calendar tax year but defer paying taxes on your revenues until the next calendar tax year. And if you operate a corporation (other than an S corporation) with average annual gross receipts of over $5 million, or if you're operating your business as a tax shelter, you can't use the cash method at all.

If you have any doubts about which method is best for you, be sure to consult an accounting services professional.

With special thanks to Supporting Strategies’ Sherri Strickland.

Topics: South Carolina, Brooklyn - Staten Island, Bookkeeping 101

Jane Lvovskiy

Written by Jane Lvovskiy

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