You are starting a new business and, as a responsible business owner, trying to figure out all the nitty-gritty details of the best accounting practices. This is a solid approach since being educated will save you lots of headaches and money.
So, which accounting method is best for small businesses?
To answer this question, we need to consider the following topics:
- The difference between cash and accrual accounting methods.
- What the IRS wants from taxpayers?
- Comparison of implementation and accounting costs for both methods.
- Tax planning opportunities for both methods of accounting.
- Future possibility of switching from one accounting method to another.
Now, let's get to the first question we need to answer to determine which accounting method is best for small businesses: What's the difference between the accrual and cash accounting methods?
Cash Basis Accounting: With cash basis accounting, income and expenses are recorded when cash is received or paid. Cash accounting does not include such terms as Accounts Receivable or Accounts Payable. We count as income and expenses only cash that hit or left our bank account. For example, you work on marketing projects for a living, and you received a big prepayment for your services in December 2023. The prepayment is in your bank account, but you still need to work on the project and deliver it to the client who prepaid for it. In the case of the cash method, you would show that prepayment on your 2023 financials as your income. However, if start working on this project a month later, but already in the next tax year (let's say in January 2024), your business expenses associated with this project you will go on your 2024 financials. This means that your 2023 financials would show a spike in income due to the client prepayment, and your 2024 financials would show a loss due to your own business expenses associated with this project. But is it a true picture of your business situation? Probably not, because you know the actual profit you made, which is the difference between the cash received for your services and the cash you spent on business expenses. But because the cash basis of accounting spread your income and expenses between two years, it is hard to figure out your actual net profit.
And that’s where accrual accounting comes in. The accrual method of accounting recognizes income and expenses when they are earned and incurred, regardless of when the cash hits and leaves your bank account. This approach provides a clear picture of your business’s financial health by matching receipts of funds with the time you actually worked on the project. For example, the same deposit that you received in 2023 as a prepayment for your marketing services won't be recognized as revenue on your 2023 financials. Instead, it will be deferred until 2024 when you finally started working on the marketing project, incurred some of your own expenses and delivered the project to your client. In the case of the accrual method, your 2024 financials will show a big receipt of cash and also a big expense for business expenses. The difference between those two will show your net profit from the project on your 2024 financials, leaving guesswork on how much your net profit is out of the equation.
Now, moving onto the second question: What are the IRS requirements on methods of accounting? Well, the IRS’s stance on this question is quite simple: whatever floats your boat. We don't care what you do with your internal accounting and how you track your profits; we only want you to be consistent with your accounting method on your tax returns. If you picked cash basis accounting on your initial tax return, please continue to file as a cash basis taxpayer in the future. If you picked accrual basis as your accounting method on your initial tax return, please don’t switch back to the cash method on the next tax return without talking to us. The IRS is only concerned about collecting tax. And to properly assess tax, they need to see tax returns on the same method of accounting from year to year.
What does this mean for a small business owner? Well, this means that the owner can decide what they need for themselves. They can go with the accrual method because they want to see a better picture of their profits. Or they can stick with the cash basis because it is of lesser maintenance. Of course, sometimes companies are required to be on the accrual basis. This could be because they are owned by investors and must show investors their financials on the accrual basis. Or the business must be on accrual due to other regulatory requirements, grants, or state requirements. But this requirement does not come from the IRS. The IRS only wants you to be consistent in your tax reporting. The IRS does have a rule that companies with big gross receipts (over 27 million) should be filing their taxes on the accrual basis. But if you are a small business, this rule does not apply to you.
In many cases, a company can have two sets of books – accrual and cash basis. This way, the company can measure its performance internally by the accrual method, but file tax returns on the cash basis. Or vice versa, the company is allowed to file tax returns on the accrual method, but for their own accounting, they can prefer cash basis financials.
That's why many accounting software platforms give you an option to print financials on both cash and accrual basis. It does not necessarily mean that accrual accounting is done correctly, but the option to pull financials on the accrual basis is available.
Now let's move to implementation and accounting costs: Cash basis accounting is simple. Everything you receive in the year is income, and everything you spend in the same year on your business is an expense. The difference between receipts and expenses is your net income for the year. This is an easy formula to grasp. Small businesses that are just starting out can recreate their bookkeeping on Excel or even on a piece of paper. There is no accounting knowledge involved (except for the formula I mentioned above), and most business owners deal with the cash method just fine. What does that mean in terms of accounting costs? This means that if you are just starting out as a side gig, and don't need a lot of complex transactions, you can save money by not hiring an expensive accountant to do your books. Again, it all comes back to the complexity of your business. Sometimes you still need an accountant just to keep up with your business transactions, but the accrual method would definitely will bring more complexity into their work.
Accrual basis is complicated. It requires tracking invoices and timing projects to capture the right moment when revenue was earned and when expenses were incurred. I have yet to see at least one small business owner who managed to grasp and implement the accrual accounting method correctly. Accrual accounting requires accounting knowledge and more time, which means hiring an accounting professional. This also means paying for more complicated accounting software that would require bank reconciliations, about which we wrote here.
As we can see, cash accounting is easier, cheaper, and something you can handle on your own in the first year when funds are tight, but it may not give you an exact picture of your business profitability. But do you really need to have an accrual set of books to correctly measure your net profit? Honestly, not always. Many businesses earn their revenue and accrue their expenses almost immediately. In such cases their profits on the accrual method will look very similar to their profits on the cash basis. For example, a small produce store that exchanges cash for products has a very short payment cycle, and its net profit on the cash basis would look almost identical to the net profit on the accrual method.
Now let's talk about tax planning opportunities for accrual and cash method taxpayers.
Accrual-basis taxpayers have a few ways to manage their taxes effectively. They can time expenses to lower income in high-earning years and defer income on advance payments until they’re actually earned. They’re also allowed to deduct year-end bonuses if paid within the first 2.5 months of the new year. They can also write off bad debts as soon as they’re determined uncollectible.
Does the cash basis lack tax planning opportunities? Not really. Cash basis taxpayers can also time income and expenses to manage their taxable income. For example, they might delay sending invoices until the new year to defer income or prepay expenses, like rent or supplies, before year-end to increase deductions. For example, if the same marketing professional we mentioned earlier receives a prepayment in 2023, they can hurry up and pay for their project expenses in the same tax year (2023). This would mean that their gross receipts and expenses would be shown on financials of the same tax year and they would net each other out and the business owner would pay less tax for 2023 tax liability.
The cash method also has another selling point. It is compatible with individual tax returns (Schedule C on form 1040). When small businesses start out, they, in most cases, start with the Schedule C on form 1040, which is very easy to follow if you are a cash basis taxpayer. Schedule C is inexpensive; it is included in your personal tax return and does not require a separate business tax return. We talked in detail about Schedule C here. Schedule C follows the same logic as a profit and loss statement that could be recreated on Excel: the IRS form shows profits on top, expenses on the bottom, and arrives at the net profit or loss for the year. This layout is very easy for a business owner to follow and to convert their own profit and loss schedule to Schedule C without any particular challenges.
Hopefully, by now you have figured out the difference between accrual and cash accounting and made your decision on one.
Now let’s move to the final question: can I ever switch accounting methods on my tax returns? The answer is yes, but you would need to let the IRS know by filing form 3115. The form is quite difficult to figure out by yourself, and you might need to account and pay in advance for all the taxable income that may be triggered by changing accounting methods. Most likely, you would also need to hire a tax CPA to do this tax filing for you.
So, which accounting method is best for small businesses? Both accrual and cash methods have their advantages. The cash method is easy to implement and less expensive but the accrual method is more accurate. In my opinion, the business owner needs to look into the way business transactions are structured in order to decide if filing as an accrual tax payer on business tax returns offers more tax planning opportunities. And if the accrual method does have more tax benefits, you would need to prepare for a more complex accounting setup and additional costs spent on CPAs and bookkeepers. It is always a good idea to talk over this issue with a tax CPA before filing your first business tax return, even if you file the tax return yourself. Switching from one accounting method to another on your tax return is a complicated and expensive tax filing procedure.
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