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Is Cash or Accrual Accounting Best for My Business Structure? by Shanna Shim, CPA

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Posted on July 10, 2024 by Shanna Shim

Small and midsize businesses generally have two options for maintaining their financial books and records: the cash and accrual methods of accounting. While each approach offers businesses unique benefits at different stages of their life cycles, business owners must recognize when they should transition from one method of financial accounting to the other.

The cash basis of accounting is a simple bookkeeping method in which companies record transactions as they receive cash or send payments. It is similar to how most individuals manage their household budgets, documenting income when they put earnings or other deposits into their bank accounts and deducting expenses when they make payments to third parties. While this can give business owners a good overview of their short-term cash positions, it does not address open accounts receivable and accounts payable, which can leave them with a skewed picture of their profitability and an inability to identify (and address) trends that can improve operational efficiency.

By contrast, business owners using the accrual method of accounting record revenue and expenses as they are earned or incurred regardless of when there is a transfer of money. In other words, a business recognizes revenue when it makes a sale and issues an invoice to a customer without regard for when the customer makes a payment. This ensures revenue is matched with expenses in the same accounting cycle, enabling businesses to gain deeper insight into the costs they incur to generate income during a specific period, whether there are seasonality changes in their sales, and which products, services and business units are more profitable than others. With this level of detail, businesses more easily identify trends and make more informed decisions about where to allocate resources.

While the cash basis of accounting is the easiest method for most start-ups and small businesses to track revenue and expenses, it is not recommended for companies in growth mode that need a complete and accurate picture of their financial position, sales performance, profitability and cost structures to make informed decisions about their future. In addition to the benefits listed above, the accrual method enables businesses to glean important information about their customers and vendors and their respective transaction histories. For example, a company could see which customers pay on time and could be extended higher or more lenient credit terms. They can also determine which vendors the business can rely on to deliver products or services on time and receive the most favorable pricing and payment terms. Moreover, only the accrual method conforms to the United States generally accepted accounting principles (U.S. GAAP) standards for consistent financial reporting and, therefore, stands up to the rigid lending requirements of banks and private equity that many small businesses rely on for funding.

Choosing an Accounting Method

There are times when the decision between cash or accrual accounting is made for a company based on its structure, size, and tax and legal requirements. For example, businesses that hold inventory, are publicly traded or have more than $25 million in sales for the previous three years must use the accrual method for tax purposes. Otherwise, businesses may choose an accounting method when they file their first tax returns and continue using that method from year to year. However, as they grow and evolve, they may need to change their accounting method, which they may do by filing with the IRS Form 3113. Under these circumstances, it is critical that businesses anticipate and plan for all the adjustments such a change will make to their existing accounting processes, including staff training and the impact on their reporting of income and taxes to shareholders and the IRS. Although accounting software systems can help expedite this process, businesses should work with experienced accounting professionals to ensure a smooth transition that accounts for all potential scenarios.

About the Author: Shanna Shim, CPA, is an associate director of Managed Solutions and Technology with Berkowitz Pollack Brant Advisors and CPAs, where she helps small and mid-size companies deploy integrated accounting systems and translate that data into actionable business intelligence.  She can be reached at the CPA firm’s Miami office at (305) 379-7000 or info@bpbcpa.com.