If I had to make a list of the top questions I am asked by clients, I would put this one near the top: “Which is the better way to track my small business’s financial performance – cash or accrual?” You ask this to any CPA and they are bound to have a different answer. This is because… there is no “one size fits all” answer. Some business should be using cash basis while others should be using accrual, and some should be using a hybrid of the two.
If I’ve already lost you, never fear. Most business owners have heard of cash and accrual in the context of accounting for their business, but few really understand the little nuances that make one method better than the other for their particular business.
Under the cash basis of accounting, revenues are recorded when cash is received and expenses are recorded when cash is paid. The foundation for accrual based accounting is called “the matching principle”. Basically, this is the idea that expenses should be recorded when an obligation is incurred. For example, cost of sales (an expense) is recorded when the product is sold not when inventory is purchased. Similarly, when a company records a sale, the sale is income to the company when the product of service is provided to the customer and not when the customer paid the bill.
True accrual accounting is complex and time consuming. In a perfect world, all businesses would be using the accrual method. It gives the most accurate picture of a company’s performance over time because of how it matches the revenues with the expense in the period that each are incurred.
For example, a car dealer buys a used car in an auction for $1,000 in January. In March, he sells it for $3,000 on credit where the customer will pay down the loan over time. In the cash method of accounting, his January Income Statement would show a $1,000 expense for buying the car and no income. Then in March, it looks like he didn't sell anything because the customer didn't pay cash for the car. This is not an accurate picture of his business’s performance at all. In the accrual method, he would record the sale for $3,000 and the $1,000 cost of the car as an expense all in March so his true profit is $2,000 in March – which is an accurate representation of his businesses performance in March.
But – a lot of small businesses will opt for the cash method because - let’s be honest now - it’s easier. A lot easier. And a lot of small businesses don’t have the extra time or money to spend on keeping their books under the accrual method – and that is ok. Like all things in business, you need to weigh the costs and benefits.
I've created a little flow chart to help you decide which may be better for your particular situation. (You can save the image or view it in another window in order to zoom in.)
