Both methods have strengths and weaknesses.
Making decisions—even small ones—about your business can have long-term ramifications if you don’t do your homework first. One of the decisions you’ll make when starting a business is what accounting method you’ll use to manage your finances.
Basically, you’ll have two options: accrual accounting or cash accounting. Each has its strengths and weakness, depending on the size and type of your business.
The method you choose affects when you are required to book your revenue and expenses.
For most non-accountants, cash accounting (cash basis) is the easiest, simplest method to understand. You book income when you receive money or when your customer pays you, not when they place an order with your business. This is similar to how you manage your personal household with your checkbook. Under this method, you don’t have to incur (and thus pay taxes) until you receive payment from your customers.
On the expense side, you generally book your expenses when you pay the vendor. This method allows you, within certain limitations, to time out your expenses and take them when you need them to control your company’s income.
Accrual Accounting—Book Revenue Sooner
With accrual accounting, you book the revenue when you make the sale that will provide you income, no matter when you see payment. You book expenses generally in the period you consume or use the item in your business, regardless of when you pay for it.
This allows for a better “matching” of income and expenses, but reduces your ability to plan for tax purposes. It also can be more difficult to track your cash flow.
Which Method Fits Your Business?
While both cash basis and accrual accounting forms are approved accounting methods for tax purposes, the use of cash method is much more restricted.
Often though, a business just starting up will have an opportunity to use the cash basis until it grows to a larger revenue size. This allows for tax planning in the critical first year of operation.
Can You Switch Methods?
In some instances, it might make sense to change your accounting method, if your company experiences a large bump in sales or your strategy changes.
Some changes are “automatic,” meaning they do not require IRS approval; others require approval. Regardless, the IRS has provided specific rules for determining your income in the year of change and in future years.
If you have concerns or aren’t quite sure which method will work best for your business, always consult your CPA first.