How to Decide Between Cash and Accrual Accounting for your Business

When you set up your business, there are basically two ways to set up your books: on a cash basis or on an accrual basis. Each method has both advantages and disadvantages. Here is the difference and how you will decide between the two methods.

Difficulty: Moderate

Instructions

1. With cash basis accounting, you will record cash receipts and disbursements only during the period in which they are actually occur. Therefore, under that method, you will recognize revenue only when it is received and expenses only when they are paid. Additionally, inventory is not accounted for. Rather, the purchase of goods is entered only during the period in which the goods are paid for.

2. Under accrual basis accounting, you will recognize revenue and expense when they are earned, even though the cash transactions to support them occur later. For example, the sale of merchandise will be booked when it is made, even if the actual cash is not received until later. The same holds true for expenses, as they are accounted for prior to their actually being paid.

3. Cash basis accounting is quite simple to implement and, therefore, it is inexpensive to use. Also, there are other benefits to using this technique. First, it does provide an accurate picture of your company’s cash flow. And, it will allow you to defer income for tax purposes by simply delaying the banking of receipts until the following year.

4. Accrual basis accounting is more complicated and expensive to implement than cash basis accounting. Also, you may owe taxes on income before you actually receive it. However, it does provide you a more accurate picture of your company’s profitability. Furthermore, if your company is listed, you will be required to use accrual basis accounting.

Tips & Warnings

• Many companies keep two sets of books, one for financial reporting purposes and the other for taxes. The Internal Revenue Service requires most companies to use accrual basis accounting, but there are a few exceptions. See your tax advisor before you decide to use cash basis accounting for tax purposes.
• When your company is on a cash basis, you will not be able to accurately measure its profit, because it doesn’t acknowledge money that might be owed at some future date. Your company could actually be losing money when it appears that it is making a profit.

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