Which accounting method is right for me – cash basis or accrual basis?

Many small business owners are unaware that they have a choice as to which accounting method to use – cash basis or accrual basis. Here is a simple explanation and guidelines to help you decide which might be the right one for you.

Cash Basis Accounting

Cash Basis Accounting recognizes expenses when they are paid rather than when they are incurred, and revenue when it is received and deposited, rather than when it is earned. It is a simple method of accounting, mainly used by small business owners. Therefore, with cash basis accounting, there are no accounts receivable or accounts payable.

Cash Basis Accounting can result in what some refer to as a “hockey stick.” Take for example, your general liability insurance policy. A business may be in a strong cash position and opt to pay for that entire policy in one lump sum. The result is the income statement will show one large payment in one month versus 12 equal payments over the 12-month term of the policy. In other words, the annual insurance payment is reflected in the month it was paid vs. being spread over the entire year. This would result in a graph that looks like a hockey stick — a sharp increase in expenses in one month followed by no expenses for the rest of the year.

The upside of cash-basis accounting is that it is quite simple and straightforward. The downside is that it doesn’t provide a realistic view of your business’s financial standing.

Accrual Basis Accounting

Accrual basis accounting recognizes expenses when they are received and revenue when it is earned (invoiced). This means a business using the accrual basis accounting method reports both accounts receivable and accounts payable on its balance sheet.

The accrual method offers a higher level of financial accuracy and also presents a greater level of financial sophistication. It allows business owners to get a much more realistic view of revenue and expenses in any given period — something that is not as visible using the cash basis method.

One advantage of this type of accounting is that it flattens out expenses so they are evenly distributed across the months. If we employ the same general liability insurance example as above, using the accrual method, the entire payment for the annual policy renewal would be captured in a prepaid expense account and then, over the 12-month policy period, the business would recognize one-twelfth of that expense each month to provide a much more realistic view of actual monthly expenses.

One disadvantage to using the accrual method is that it does not afford a business any greater awareness of current cash flow. This means a business should also carefully monitor its cash position regularly.

Which method is right for you, accrual or cash basis accounting?

Determining which method is right for your business depends on how critical it is for you to predict expenses accurately as well as the level of financial sophistication you desire.

If you are a small business with lower revenue and no payables, cash-based accounting may be the right approach.

If you are a contractor juggling multiple jobs, for example, and need to understand job costing, you will benefit more from the accrual method.

Whichever method you adopt, rest assured that ARI is here to help you take better control of your accounting function and provide you with the expertise and guidance to better understand your financial statements.

Together, we can determine the best accounting method for your business goals. To explore if ARI can improve your business’s accounting practices, contact us today.

Summary

Choosing between cash basis and accrual basis accounting depends on your business’s size, complexity, and need for financial accuracy. ARI can help evaluate your operations and identify which method best supports your financial goals.

FAQs

• What is the main difference between cash basis and accrual basis accounting?

  • The main difference is when revenue and expenses are recognized:
    • Cash basis accounting records income when cash is received and expenses when they are paid. There are no accounts receivable or payable under this method.
    • Accrual basis accounting records revenue when it is earned (invoiced) and expenses when they are incurred, regardless of when cash actually changes hands. This method includes accounts receivable and accounts payable on the balance sheet.

• Which accounting method is better for small businesses?

  • There isn’t a one-size-fits-all answer, it depends on your business needs:
    • Cash basis can be better for very small businesses with simple transactions, low revenue, and no payables, because it’s straightforward and easy to manage.
    • Accrual basis may be better for businesses that need a more accurate financial picture, especially if they handle multiple jobs, have credit transactions, or need to understand profitability beyond just cash flow.

• When should a business use accrual accounting?

  • A business should consider accrual accounting when it needs a more realistic view of revenue and expenses over time, manages accounts receivable and payable, or carries inventory, or has multiple jobs or contracts where timing between billing and cash receipt varies.

• Can a business switch from cash basis to accrual basis accounting later?

  • A business can switch methods later as its needs change (growth or complexity increases). Many small businesses start with a cash basis for simplicity and transition to accrual as they require more detailed financial insights or external reporting.

• How can ARI help me choose the right accounting method?

  • ARI will evaluate your business’s financial activity and goals to recommend the method that fits your needs then implement the chosen accounting method correctly in your books. We also provide ongoing support and expertise so you understand how your financial statements reflect your business performance.