Keeping track of your financial situation is an integral and vital part of running a business. 

Whether you’re a seasoned business owner or just getting your first business off the ground, it’s important to understand the basics of accounting (even if an accountant handles the details for you). One of the most foundational elements to grasp is the type of accounting method you use to track your finances.

There are two main accounting methods that most businesses use: cash-basis accounting and accrual-basis accounting.

Here we’ll cover all your questions about the differences between cash and accrual-basis accounting, as well as how to choose an accounting method and why accounting is a critical part of running your business.

The Importance of Accounting in Running Your Business

In short, accounting helps you: 

• Track income and expenses
• Evaluate the performance of your business
• Make sure your business is in compliance with state and federal statutes
• Address taxes and other liabilities appropriately
• Provide investors and company leadership with financial information to help set a budget and make future projections

Proper accounting gives you financial statements that provide vital information about your business, including profits, losses, and your overall financial position. These statements help you make more informed business decisions. 

In most cases, your financial statements must also be filed with the proper state and federal authorities. In Minnesota, businesses are required to file their financial statements annually with the Secretary of State. Public companies are also required to file them periodically with the Securities and Exchange Commission. 

Key Differences Between Cash and Accrual-Basis Accounting

Cash and accrual-basis accounting are the two most common accounting methods used by businesses. Depending on your business model, one may work better for you than another.  Ultimately, there are three key differentiating factors between the two: timing, complexity, and responsibility. Let’s take a closer look.

Cash-Basis Accounting

In cash-basis accounting, revenues and expenses are recognized at the time they are received or paid. 

This method focuses on your business’ cash flow, with a particular emphasis on cash on hand: Money that comes in is tracked as revenue; money that goes out as expenses paid. Revenue is reported on the income statement only when cash is received; expenses are recorded only when cash is paid out.

The biggest benefit of this method of accounting is that it is simple and easy to understand.

It allows a business to easily answer questions regarding their annual revenue, expenses, and financial losses. It’s also easier to align earnings with important dates, ensuring you pay your taxes on time.

Another benefit of cash-basis accounting is that you only have to pay taxes on money you’ve received — not on invoices you’ve issued — which can help cash flow. (However, not all businesses are allowed to use cash-basis accounting, so it’s important to confirm with state and federal authorities that your business is eligible for this accounting method.)

On the downside, cash-basis accounting makes it more difficult to grasp a business’ current financial health, as accounts receivable and payable are not used. Without this critical information, you can end up with big discrepancies in your records, and your financial statements could overstate the health of your company if you are cash-rich.

It also doesn’t help when you’re making management decisions, as you only have a day-to-day view of your finances.

Accrual-Basis Accounting

In accrual-basis accounting, revenues and expenses are recognized at the time of the transaction—even if the cash isn’t in or out of the bank yet. 

Revenue is recorded when a product or service is delivered to a customer with the expectation that the customer will pay for it in the future. Expenses are recorded before cash is actually paid out for them.

This accounting method involves tracking accounts receivable and payable to create an accurate picture of the financial status of your business. In case you’re not familiar:

• Accounts receivable is money owed by customers for products or services rendered
• Accounts payable is money your business owes to vendors or creditors

This method of accounting provides a more accurate picture of your business’s financial situation, as it takes more into account than cash flow.

On the downside, accrual-basis accounting is complex, requires much more detailed record keeping than the cash method, and can be time consuming. 

Many businesses, as they grow, find they need to outsource the bookkeeping and accounting tasks. As such, this method can be more expensive than cash-basis accounting, and therefore more difficult for smaller businesses to use. In some cases, it might make sense for a small business to start with the cash-basis approach and switch to the accrual-basis method as the company grows and requires greater accountability.

In addition, with the accrual-basis method, you may end up having to pay taxes on income before the customer has actually paid you. (However, if the customer doesn’t pay the invoice, you can claim the tax back on your next return.)

Choosing the Right Accounting Method for Your Business

When To Use Cash-Basis Accounting

The cash basis method is most often used by sole proprietors and smaller businesses with no inventory.

For newer or very small businesses, knowing exactly how much cash is available can be helpful to determine when or how quickly bills get paid. And in most cases, because it is so straightforward and easy to use, this method of accounting doesn’t require hiring additional staff. 

Plus, smaller businesses’ earnings tend to fall below the $25 million per year threshold for using cash-basis accounting set by the IRS.

For businesses with inventory, cash-basis accounting is typically not a good fit because it doesn’t allow for the accounting of inventory at the opening and closing of each tax year (though there are some exceptions to this rule).

When To Use Accrual-Basis Accounting

Accrual-basis accounting is the most commonly used method for larger companies (especially publicly-traded companies). The finances of larger businesses often have too many moving parts for the simple cash-basis method. The accrual method allows for more complexity.

A few examples of how the accrual method is beneficial:

• Credit card payments. Such payments can post days or weeks after the transaction initially occurs. The accrual method provides a way to track those payments before they’re actually received/sent.
• Tracking assets and liabilities. Accrual-basis accounting makes it easier to distinguish assets and liabilities by keeping up-to-date records of what items fall into either category and for how long.
• Ensuring GAAP compliance. Publicly-traded companies in the U.S. must adhere to the Generally Accepted Accounting Principles (GAAP) as determined by the Financial Accounting Standards Board (FASB). These businesses are required to use accrual-basis accounting, as the cash-basis method doesn’t meet GAAP standards.

Additionally, accrual-basis accounting offers a more complete picture of a company’s financial situation—one that cannot be easily manipulated or misconstrued. The accrual method requires everything to be accounted for in a timely manner.

We hope this information is useful to you as you determine which accounting method is best for your business. The team at OIB would love to be a resource for your business: for more helpful information, browse our previous blog posts and consider following us on LinkedIn. 

And when you’re ready to discuss buying or selling a business, contact us to get started!