When you start a small business, there are a number of initial decisions you have to make. One of those decisions is what type of accounting method you are going to use in your small business. How are you going to record your financial transactions? You can use either a cash system of accounting or accrual accounting. Which method of accounting you choose depends on several factors.
Cash and Accrual Accounting Systems
A cash accounting system is based on cash flow. You record transactions when cash is actually exchanged. Income is recorded when you receive a cash, credit card, or check payment. Expenses are recorded when you pay them by cash, credit card, or check. Your particular business or industry may also have alternative methods of payment. Cash accounting systems are usually used by smaller, simpler businesses.
An accrual accounting system is based on when the transaction happens rather than on when cash changes hands. If your company earns income in January but isn’t paid until February, then the income isn’t recorded until February under the cash accounting method, but it would be reported in January under the accrual accounting method. Larger, more complicated businesses usually use an accrual accounting system.
If you extend credit to your customers and allow them to purchase items and pay for them at a later time, then you are incurring accounts receivables. If you record the accounts receivables when you incur them, that is accrual accounting. If you record them when you receive payment, that is cash accounting.
Choosing Your Accounting Method
In the real world, not many businesses operate on a purely cash accounting method because you often sell products and are paid later or other types of transactions occur and payment or income is received at a later time. Using an accrual accounting method gives you a better picture of your income and expenses and, as a result, your profitability. Accrual accounting also requires the use of double-entry bookkeeping. Double-entry bookkeeping means that you have to have knowledge of the accounting equation. Cash accounting, if you choose this accounting method, gives you a better idea of your cash flow.
When you file your first tax return for your small business with the Internal Revenue Service, you need to report your choice of accounting method. You are required to use the accrual method of accounting if any of the following three conditions apply to your business:
- Your company is a C corporation.
- Your company has inventory.
- Your gross sales revenue is greater than $5 million. There are exceptions to this rule that you should discuss with your tax accountant.
If these conditions do not apply to you, and if at some later date, you choose to change your method of accounting, you need to file IRS Form 3115, Change in Accounting Method, with the Internal Revenue Service.