For a traditional small business, there is no right or wrong method for accounting. However, cash versus accrual always seems to be a hot topic that small business owners and entrepreneurs want the answer to. I am glad that this question is constantly being explored because accounting for small businesses is extremely important, along with choosing the correct accounting method for your own small business. Each method has its own advantages and disadvantages and this article from NOLO online does a great job of exploring both.
The cash method (or cash basis) is the more preferred of the two accounting methods. Income, sales, and revenues are not recorded until the cash is actually received. Expenses are also not recorded until the cash is paid out. This is a very simple method and it sticks by its name. This method gives you a more accurate depiction of how much cash you really have. On the down side, it can portray a distorted picture of long-term profitability. You can have a month where sales are slow but receive customer credits from the last three months. In this instance, although sales are low this month, the records show sales from the past three months all being recorded in the same month. A business must keep monthly totals of accounts to understand the books completely. As long as you understand the delay in recording income and expenses, small businesses can have great success using this method.
The accrual method (or accrual basis) records a transaction when the expense or sale is incurred rather than when the cash is paid-out or received. For service-based companies, you record the sale when the service is 100% completed. This goes for expenses, as well. This method is great for showing business income, expenses, and debts as they are incurred. The downside is that it may not give you an accurate picture of what your cash flow looks like. For instance, you can have thousands of dollars in sales but your bank account does not reflect this because your customers haven’t paid yet. It is important when using this method to constantly remind your customers of what they still owe and to keep a close eye on your bank accounts.
When choosing the correct method for your business, there are a couple of things to keep in mind. The first is that if your business has sales over $5 million in sales you must use the accrual method. Next if your company sells products to the public and you have an inventory, you must use the accrual method when gross receipts exceed $1 million. As long as your businesses sales are under those two thresholds you are able to choose either of the methods. You can even switch from one method to the other, as long as you consult with your tax expert first. As far as tax deductions go, under the cash method you cannot claim deductions if they are incurred in 2012 but paid in 2013. Under the accrual method you can record those expenses when incurred and claim them in 2012.
I hope this helped answer some of your questions regarding cash vs. accrual methods of accounting. For more information check out the article on NOLO online or consult with your accounting/tax expert.