Cash vs. Accrual: Which Accounting Method Works Better for Your Business?

Every business must have an accounting method that governs how and when to report revenue and expenses. The accounting method you choose can help guide financial decisions for business activities, impact your taxes, and even affect the ability to obtain a commercial loan.

What Are the Most Common Accounting Methods Used by Small Businesses?

Businesses use two primary accounting methods to record and report financial transactions: cash-basis accounting and accrual-basis accounting.

The difference between the two methods lies in when income and expenses are recorded. The timing of each accounting method can affect profit, loss, and income taxes.

The cash method is generally easier to use, but the accrual method can provide a more accurate picture of a business's financial performance. Each comes with its own positives and negatives. Continue reading to determine which may be most suitable for your business needs.

As a business owner, it is important to acknowledge where you are receiving income and what routine costs you can expect. By better understanding the flow of cash to your business, you may be better prepared to handle accounting and select the accounting method most suitable for you.

The most common sources of small business expenses include:

• Payroll
• Office space
• Utilities
• Equipment & Supplies
• Inventory
• Insurance
• Advertising/Marketing

Cash-Basis Accounting

The cash method is the easiest accounting method to understand and follow. Due to its simplicity, most small businesses and individuals choose to operate on a cash basis and prepare their income taxes using this method.

Under the cash method, income is recorded when payment is actually or constructively received. Constructive receipt means an amount is credited to your account or made available to you without restriction. For example, let’s say you receive a check in December for the services you performed. You don't cash the check until January, but you must report the income in December as you had control over it then. If you're paid in property or services rather than in cash (including a check, credit card, or electronic transfer), the fair market value of the property or services is considered income when received.

Under the cash method, expenses are recorded when they’re paid to vendors for purchases of products or services. For example, your rent is due on the first of the month. If you pay early, say the 28^th of the previous month, that's when you record the payment. If you pay late, such as the 5^th of the month the rent is due, that would be the day the expense is recorded.

Accrual Accounting

Under the accrual method of accounting, revenues are recorded when fully earned, and expenses are recorded when incurred, rather than recording revenues and expenses as they occur or when the payment changes hands. More specifically, income is recorded when all the events that allow you to receive it have occurred. That allows you to conduct an "economic performance test" to determine with reasonable accuracy what that income truly is.

For example, let’s say you receive an order, fulfill it, and ship the goods. You would record the income upon shipping because all events have occurred to create your right to payment, and you would be able to determine what that payment amount should be. You don't wait until payment has been received.

The same rules govern the treatment of expenses. For example, your rent is due on the first of the month. Per the accrual method, this is the date for recording the expense — it doesn't change whether you pay early or late.

Hybrid Method of Accounting

There is a third accounting method the IRS allows under certain circumstances — the hybrid method of accounting. This method, however, is typically not used because it is less clearly defined and more difficult to manage. The IRS allows for any combination of cash and accrual methods if:

• The hybrid clearly reflects your revenue and expenses, and
• You apply the method consistently.

As you can see, this definition is quite broad and allows for a great deal of interpretation, which can be problematic in the event of an audit. For most business owners, choosing either the cash or accrual method and applying it consistently is the best option.

How To Choose the Right Accounting Method for Your Business

For tax purposes, the accounting method that you use is crucial because it determines when you recognize income and deduct expenses. In some cases, some businesses can't use the cash method and must use the accrual method. However, recent tax law changes have expanded the opportunity to use the cash method if desired.

All accounting methods have advantages and disadvantages, and there isn't one method that will work the most effectively for every business. As a small business owner, it's important to understand the advantages and disadvantages of cash vs. accrual accounting to decide what is right for your business.

• Cash-basis accounting is easier to understand and use. Because the cash method is intuitive — you report income when received and note expenses when paid — it may not be necessary to seek the help of a professional bookkeeper or accountant. You can easily record transactions in your accounting software (discussed below).
• Cash-basis method shows cash flow. Because the cash method follows the flow of income in and out of your business, it provides a more accurate picture of how much cash your business has available on hand. In other words, monitoring cash flow parallels your accounting method.
• Accrual accounting can delay cash flow. One downside to using the accrual method is that it can paint a delayed picture of cash flow since it records income and expenses when they are earned or incurred, not when cash actually exchanges hands. This can sometimes create a situation where a business appears profitable on paper but struggles with cash shortages.
• Invoice factoring as a cash flow solution. To address cash flow challenges, companies can consider invoice factoring. This financial strategy allows businesses to leverage their accounts receivables by selling them to a third party at a discount, providing access to working capital. It's a practical choice for businesses that want to manage their cash flow. This helps them meet immediate financial needs, even with delays from accrual accounting.
• The cash accounting method doesn't have the same control as the accrual method. Transactions can be more easily systematized under the accrual method, giving greater ease of posting them and reducing the chance of errors.
• Cash-basis accounting can be misleading. The cash method doesn't show the full picture of income. For example, it doesn't reflect income that's been invoiced but not yet received, and it doesn't consider future expenses that the business will have to pay.
• The cash method is barred to certain big businesses. A C corporation (or a partnership with a C corporation partner) cannot use this method if its average annual gross receipts for the three preceding years exceed a set dollar amount ($26 million in 2020). This is called the gross receipts test.
• Cash-basis method is barred to larger companies under certain accounting principles. As explained below, big businesses must use the accrual method to conform to accounting principles.

When Should You Use Cash-Basis Accounting?

• You're starting out your business. The cash method is generally easier to use than the accrual method, so when you’re starting out, you may want to keep things simple.
• You want better control over taxes. This method provides latitude near year-end to defer or accelerate income and/or expenses. For example, if you perform services in December, you can delay billing so that payment is received (and is taxable) in the following year.

When Would You Use Accrual Accounting?

• You have an inventory. If you do not qualify under the gross receipts test noted above, you must maintain inventory. Doing so under the accrual method is standard operating procedure.
• You want to stay on top of receivables and payables. In the cash method, you only report results (the receipt of revenue or the payment of an expense). But if you want to keep tabs on what's outstanding so you can follow up as needed, the accrual method gives you a better handle on your accounts receivable (A/R) and accounts payable (A/P).
• You want a long-term view of your company's financial situation. It's easier to see what's happening within a set period, so you can know when the business is growing or slowing and take action accordingly.
• You need to conform to GAAP. The Generally Accepting Accounting Principles (GAAP) standard for accounting rules requires most businesses with revenue over $25 million to use the accrual method, so financial reporting conforms to these rules.

Other Accounting Methods

Other types of accounting methods take the place of cash or accrual and are used in special situations. Examples of other accounting methods businesses use include:

• Installment method. Whether you use the cash or accrual method, you can also use the installment method to report gain from a sale in which payment is received in more than just the year of sale. This allows you to spread the gain and more closely align tax reporting with the receipt of payments. This method doesn't apply to inventory sales.
• Percentage of completion method for long-term contracts. This method is commonly used in the construction business, where erecting a building can take considerable time. It applies when contracts extend into the following year and allows for deferral of income and expenses until contracts are completed (with limitations). Small contractors and larger contractors' home construction contracts are exempt from using this accounting method.

How Accounting Software Can Help

Accounting programs can be helpful when determining which accounting method to use. You don't have to be an accountant to be able to record your income and expenses accurately. Most accounting software lets you set up your system using the cash or accrual method. Some software even lets you switch between these methods to view reports.

This can be useful when analyzing how each method affects your profit, loss, and taxes. But keep in mind that if you use one method of accounting and want to make a change, you must file for a change in accounting method with the IRS and make any payments for doing so.

Sync Business Accounting With Payroll and HR Administration

No matter which accounting method you choose, integrating it with Paychex Flex® is a fantastic decision for many businesses. Paychex Flex® combines your accounting, HR, and benefit needs into one easy-to-access platform. If you’re looking to integrate with a different financial platform, we have hundreds of options allowing you to transfer data to Paychex Flex seamlessly.

Businesses that connect their accounting software with their payroll and HR platform make fewer mistakes. This integration saves time and reduces errors from manual data entry. In addition to reducing potential errors, businesses can also access Paychex’s business knowledge center, state compliance library, and HR library. Perhaps even more helpful is guidance from an HR business partner.

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