Finance: Cash vs. Accrual Accounting

February 3, 2010

Which is Best for Your Biz?

The common accounting methods are called the “cash method” or the “accrual method”.

Under the cash method, the accounting for sales is deemed to occur when payment is received and expenses are accounted for when payment is made.

Under the accrual method, sales are deemed to occur and are accounted for when the revenue is earned, whether paid for or not, and costs are accounted for when expenses are incurred, even if not yet paid. An example is a painting company which incurs cost when their materials are invoiced to them and books sales when it bills the customer at the end of the job. The expenses and the billing are charged to the month when they were invoiced, even though they were not necessarily paid or paid for until some time after that.

Most small businesses use the cash method of accounting because of its simplicity. However, as your business grows, the accrual method gives you a better picture of your business, assuming that accounts receivable are not an issue.

If significant inventory is necessary , the accrual method may have to  be used. A combination/ hybrid method may also be permissible. For example, if inventories are necessary to account for your income, you must use the accrual method for purchases and sales. However you can use the cash method for all other items of income and expenses. Federal IRS rules lead to some accounting method choices and require permission from the IRS if changes become necessary. See your IRS office for direction or consult with an accountant well-informed on the current rules and their interpretation. The accrual method of accounting may be required of all businesses with gross sales over a certain amount.

Even if you use the accrual method of accounting to help you to manage your business, your IRS return will be filed on a cash basis. If you are planning the sale or purchase of a company, it is important that everyone understands which accounting method is being used for review and why there might be any significant differences.

Bill Haman, SCORE Cincinnati
View more posts by Bill

Filed under: Finance,Managing,Planning

Tags: accounting, accrual, bookkeeping, cash, Finance