The choice between cash and accrual accounting is one of the first decisions a new business must make. It affects how your financial statements look, when you pay taxes, and how accurately your books reflect the economic reality of your business.
Cash Basis Accounting
Under cash basis accounting, you record income when you receive payment and expenses when you pay them. This method is simpler, easier to understand, and often results in better tax timing for businesses that can control when they receive payments and make expenditures. Most sole proprietors and small service businesses use cash basis.
Accrual Accounting
Under accrual accounting, you record income when it is earned (when you deliver the product or service) and expenses when they are incurred (when the obligation arises), regardless of when cash changes hands. This method gives a more accurate picture of profitability but is more complex. Businesses with inventory must generally use accrual.
Key Takeaways
- Cash basis: simpler, cash matches books, better for businesses with timing control over payments.
- Accrual: more accurate economic picture, required for businesses with inventory over certain revenue levels.
- Most businesses can switch from cash to accrual, but switching requires IRS approval and can create a tax impact in the year of change.
