Q. As the New Year approaches, I am considering switching from cash accounting to accrual accounting for my small business. Do you think this makes sense?
A. This is an issue with much nuance. The Internal Revenue Code requires some companies to use accrual accounting for tax purposes. It’s best to consult a CPA to see if your business falls into this category. However, most small businesses can choose to use either accounting method.
Let’s get a working (albeit somewhat simplified) definition of each method. In cash accounting, the company recognizes revenue when it receives payment. Expenses are recognized when payments are made. Accounting entries occur when cash enters or leaves the organization.
In accrual accounting, the company typically recognizes revenue when invoices are sent (for example, when product is shipped or when a job is completed). Expenses that are directly tied to delivering a product or service are recognized at the same time that the revenue for that product or service is recognized. This way, the company can match revenue and its associated expenses.
Each method has advantages and disadvantages. The biggest advantage of cash accounting is that it’s simple. The company recognizes revenue when it receives the cash. It recognizes expenses when it sends payment. With accrual-based accounting, the company matches revenue and expenses regardless of the timing of cash movement. This creates the need for a series of other balance sheet items to account for the timing differences between revenue or expense recognition and cash movements. Inventory, accounts receivable and accounts payable are examples of such accounts.
Another benefit of cash accounting is that it typically has the effect of deferring some taxes, because it typically recognizes revenue more slowly and expenses more quickly than accrual systems. For example, a company starts a $25,000 job on December 1 and completes it on December 15. The company pays $15,000 for materials and labor used on the job in December. The customer pays on January 20.
With accrual accounting, December will show a $10,000 profit (because the company will recognize both revenue and expenses when the job is completed). The company will need to pay taxes on the $10,000 in the current year.
With cash accounting, December will show a $15,000 loss (because expenses, which the company paid in December, are recognized). Current year taxes will be reduced due to the $15,000 loss. However, next year’s taxes will be increased by the $25,000 profit that will occur when revenue is recognized in January. If the company’s marginal tax rate remains unchanged, it will pay the same amount of tax, but the tax will be deferred if cash accounting is used.
The big advantage of an accrual system is that it provides better information for management decision making. Again, consider the example above. With cash based accounting, December would show a $15,000 loss on the job because the company recognized expenses with no revenue. Unfortunately, this is misleading, since the job was actually profitable. Accrual based accounting would show the job making $10,000 in December ($25,000 of revenue minus $15,000 of expense). This accurately reflects the profitability of the job and enables management to make better decisions.
Our advice is that all but the smallest of businesses should use accrual based accounting for management decision making. If a business is so small that the owner can keep the economics of every job and/or every product in his or her head, then cash accounting is fine. If not, we recommend accrual accounting. But, what about the tax benefit of cash accounting? The good news is that you don’t have to give it up! You can use accrual accounting for management decision making and cash accounting for taxes. Under any circumstances, it’s advisable to check with your CPA before making important accounting decisions.