New business owners spend a lot of time making decisions. They decide where to operate their business, how many employees to hire and what type of advertising to invest in. One decision business owners must consider is whether to use cash-basis accounting or accrual-basis accounting. Most large businesses use accrual-basis accounting. Small businesses can use either method.
Cash-basis accounting requires less complex record keeping than accrual accounting. Accrual accounting requires the business to analyze each account at the end of the month and record entries to recognize income whether or not the company receives payment for its product or service. Accrual accounting also requires the business to record expenses that have not been paid if the company incurred the expense during the month. Cash-basis accounting simply requires the business to record income when it receives payment and expenses when it pays them. This eliminates the process of analyzing each account at the end of the month.
Income Tax Application
Many small-business owners report their business income on their personal income tax return. To report their business income, small-business owners include Schedule C with their return. Schedule C lists most expenses that small-business owners incur. These expenses must be paid in cash during the tax year to be deductible. All sales must be received in cash during the year to be reported as taxable income. The small-business owner using cash-basis accounting already has the cash amounts recorded for these sales and expenses.
Many small businesses struggle with maintaining a positive cash flow. The business owner needs to focus on his cash flow to ensure that he maintains enough cash to pay his bills. Extending credit to customers means that potentially some customers won’t pay their bills. Businesses using accrual accounting include these transactions as sales. Businesses using cash accounting do not include these sales until they receive payment. This allows the business to recognize that its sales represent cash received. The business owner has a constant understanding of where her cash flow is.
Who Uses Cash Accounting
Not all businesses are eligible to use cash-basis accounting for their accounting method. A business cannot be publicly traded and use cash-basis accounting. Also, a company must have sales of less than $5 million annually or have gross receipts of less than $1 million annually if the company stocks finished-goods inventory.