There are times when cash accounting might seem like the best option. Smaller businesses and startups are free to choose between cash accounting and accrual/GAAP accounting. Timing is the main difference between the two accounting methods.
Unlike cash accounting, which only records transactions at the time cash is paid or received, accrual accounting immediately recognizes the value the moment it is performed, spent, or earned regardless of whether you receive payment for it or not. If you are wondering whether the cash accounting method is the right option for your business or not, you have come to the right place.
What Is Cash Accounting?
The cash basis accounting method is usually the most basic. Cash accounting is straightforward and focuses on cash received and paid. It is normally used by small businesses and for personal accounting. A cash-based accounting system recognizes revenue and expenditure only when cash is exchanged, regardless of whether the product or service has been delivered. This helps ensure that additional complexities, such as current assets and liabilities, receivables, and payables, are not introduced.
It also means that the sales and expenses do not reflect the exact period they accrue in the financial statements and show investments as expenses. Thus, it can be difficult to assess the performance of your business using cash accounting.
Benefits of Cash Accounting
Cash accounting is used to this day because it offers a few benefits. For instance, it would allow you to record advance payments made by customers in your income statement the moment you receive them instead of recording them as a prepayment until you have provided the product or service. This means that small businesses can benefit from a ton of creative freedom for manipulating their statements according to a style and context that suits them best.
Besides, it would allow for easier internal tracking. But, even though a custom reporting system might work for you, it does not mean that it would make sense to others, such as investors and the IRS. It explains why large corporations and public companies cannot use cash accounting.
Impacts Income, Profitability, and Taxation
If you decide to use this method of accounting, you need to understand that it would affect your income, profitability, and taxation. It is crucial that you choose the right accounting method, as it would affect your taxation. The more profitable your company, the more money you would need to pay in taxes.
When you make spending choices for lowering your net profit, you get to reduce your tax obligations. It is common for companies to opt for the cash method to stock up on assets and avoid appearing profitable. For instance, you would be able to pay the lease for your office for the entire period and record the expenses to decrease your profit margin considerably. Even though it might seem somewhat dodgy, you are legally permitted to do so to establish your business for success in the future. However, it is due to this reason that the IRS often does not allow companies to use cash accounting, as they can simply buy inventory in bulk to appear unprofitable. Moreover, with larger companies, you have to account for bigger complexities which make cash accounting a never-ending headache.
When Can Small Businesses Use Cash Accounting?
In order to be qualified for filing taxes with the cash accounting method, the IRS requires businesses to pass their test of gross receipts or sales to make sure that organizations are under the revenue threshold, as mentioned below.
Small business entities (C corporations and partnerships) need to generate under $10 million in annual sales over the last three years.
Both a sole proprietor and an S Corporations need to generate under $1 million per year or $5 million in annual sales during the past three years.
On the other hand, the following companies will find the cash accounting method to be a great choice:
Qualified Personal Service Firms and Small Service Businesses
Accountants, real estate agents, consultants, therapists, lawyers, and other professionals as well as small group companies that provide services or a simple product can opt for the cash accounting method. Generally, these businesses operate as sole proprietors, partnerships, or privately held companies.
Family-Owned Farms
Family farms also have the option to use the cash accounting method for tax purposes as long as they do not generate over $25 million a year. Farms that are run as family entities are a special exception. Otherwise, the IRS does not raise its threshold. There are specific stipulations that you need to be aware of if you are running a farm. Although family farms may be able to use the cash accounting method for filing taxes, they would be unable to account for grains for resale, livestock costs, and other farming costs.
Freelancers and Individuals
The cash accounting method is also widely used by independent contractors, personal businesses, and other self-employed persons. There are certain complexities that you need to deal with in order to ensure that you are able to meet the requirements set by the IRS. Generally, the procedure is quite straightforward.
What If Cash Accounting Is Not Right For A Small Business?
After reading the above, you would have gotten an idea that using the cash accounting method is only acceptable for a few businesses. The fact is that the majority of companies, regardless of their size, realize that the accrual method offers plenty of benefits, especially if they wish to grow. Besides, you would need to switch to GAAP once your company generates over $3 million a year.
A great reason to switch to accrual accounting from cash accounting is that it is cheaper. Your CPA would only need to file extra forms to make the switch. The earlier you adopt accrual accounting, the cheaper it would be.
What Is Accrual Accounting?
Accrual accounting is an accounting method that requires companies to record revenue before payment is received for goods or expenses are due. This means that you would need to account for income and expenses based on whether they have been accrued or not rather than the exchange of money. Thus, the revenue generated by the organization would be recognized in the accounting books as soon as it is earned rather than cash transactions occurring, which makes it the complete opposite of cash accounting, which only focuses on cash transactions.
How Does Accrual Accounting Work?
The main concept behind accrual accounting is that an economic event needs to exist to be recognized. It is based on the matching principle, which focuses on matching revenue and expenses to the period when the transaction first occurs instead of when payment is received or made.
The accrual accounting method combines current cash inflows and outflows with future expected cash flows to provide a more accurate idea about where the company stands at a specific date.
How Can You Qualify For Accrual Accounting?
The thing about accrual accounting is that it is considered to be the standard for most organizations. However, only a few small businesses do not follow the method. Small businesses are permitted by the IRS to select their preferred method. However, if your revenue is greater than the specified threshold, you would need to opt for accrual accounting.
What Are The Benefits of the Accrual Accounting Method?
There are plenty of advantages of using the accrual accounting method, as mentioned below.
The Option to Increase Revenue
A major benefit of the accrual accounting method is that it allows you to increase your revenue. This can help you secure a bank loan and pay tax during a period when the tax rate has been reduced.
A Clear Picture Of A Company’s Financial Position
Another reason why you should consider the accrual accounting method is that it provides a clear picture of your finances. It sets the basis for preparing financial statements which you can analyze to determine where your company stands.
Real-Time View of Finances
By following the accrual accounting method, you get to receive a real view of your finances. This means that you would be able to determine if your finances are in order or not.
Good Management of Debt and Income
When you stick to a cash accounting method, you would have no idea about your debt and income. This is not the case with accrual accounting.
Conclusion
By this time, you should have the knowledge you need to understand the cash accounting method. If you are contemplating whether to opt for the cash accounting method or the accrual accounting method, it is crucial that you reach out to an expert to help you. Consult with a professional who has expertise in both of these accounting methods and can determine which method you should select so that you can organize your finances, face audits, and pay your taxes with ease.
Sound Accounts offers superb bookkeeping support and advice based on years of experience helping countless businesses organize their finances and use this information to make better business decisions. Contact us today to make a change in your business bookkeeping.
For some quick answers to bookkeeping questions, see our frequently asked questions below.
FAQ
What is the cash accounting method?
A cash-based accounting system recognizes revenue and expenditure only when cash is exchanged, regardless of whether the product or service has been delivered. This helps ensure that additional complexities, such as current assets and liabilities, receivables, and payables, are not introduced.
It also means that the sales and expenses do not reflect the exact period they accrue in the financial statements and show investments as expenses. Thus, it can be difficult to assess the performance of your business using cash accounting.
What is the accrual accounting method?
Accrual accounting is an accounting method that requires companies to record revenue before payment is received for goods or expenses are due. This means that you would need to account for income and expenses based on whether they have been accrued or not rather than the exchange of money. Thus, the revenue generated by the organization would be recognized in the accounting books as soon as it is earned rather than cash transactions occurring, which makes it the complete opposite of cash accounting, which only focuses on cash transactions.
Accrual basis accounting might not be as simple, but it gives a more accurate picture of your long-term finances.
Why use the cash accounting method?
Because of its relative simplicity, many smaller businesses utilize this system of accounting. It has the quickest learning curve and is generally considered the easiest for new business owners.
However, you need to do your research and likely discuss this with a qualified accountant, bookkeeper or tax professional to make sure you fall within all the rules governing this accounting method. Even if you are qualified to do so, you may want to use the accrual method if you’d like a system of accounting that gives you a broader view and a more long-term look at your finances.
