Cash-Basis Versus Accrual-Basis Accounting

One of the basic accounting decisions a business must make is whether to use the cash basis or accrual basis of accounting.

The difference generally comes down to timing: when income and expenses are recorded.

Under the cash method, income is generally recorded when payment is received. Expenses are generally recorded when they are paid.

For example, assume you complete a project for a customer in December but do not receive payment until January. Under the cash method, the income would generally be recorded in January.

Cash-basis accounting is often easier to understand and maintain. It may work well for small service businesses that are paid quickly and do not carry significant inventory.

Under the accrual method, income is generally recorded when it is earned, even if the customer has not paid yet. Expenses are generally recorded when they are incurred, even if they will be paid later.

Using the same example, income from a project completed in December would generally be recorded in December, even if payment is received in January.

Accrual accounting may provide a clearer picture of business performance because it matches income with the expenses related to earning that income.

Neither method is automatically better for every business.

Cash-basis accounting may be appropriate when:

• The business is relatively small.
• Customers usually pay immediately.
• The business has limited accounts receivable.
• The owner wants a simple way to track cash activity.

Accrual-basis accounting may be helpful when:

• Customers are invoiced and pay later.
• The business has significant unpaid bills.
• The business carries inventory.
• Management needs detailed financial reporting.
• The business is growing or seeking financing.

Some businesses may also be required to use a particular accounting method for tax or financial-reporting purposes.

The accounting method you choose affects your financial statements and may affect when income and deductions are reported for tax purposes. Changing methods may also require additional tax filings or approval.

Before selecting or changing an accounting method, speak with a qualified tax professional. The right method should meet tax requirements while also providing useful information for managing your business.