Cash or Accrual: Which Accounting Method is Best for Your Small Business?

Accounting. It can be a very intimidating concept. Even if you decide to use an outside bookkeeper for your accounting needs, knowing basic accounting methods will help you understand your small business. Your choice of an accounting method will directly affect how you keep records and report your income to the IRS. (See IRS Publication 538, Accounting Periods and Methods.)

Cash Method

Most people use the cash accounting method for their personal finances and record transactions in a checking account as they occur. If you choose to use the cash method for your small business, you'll generally report income and expenses as you acquire them during the year.

If you run a service business, cash accounting may be the method for you. However, if you give customers credit or pay for business expenses on credit, your business income may be inflated because you haven't deducted these expenses from income.

Accrual Method

If you use the accrual accounting method, you'll report income as you earn it and expenses in the year they occur. Although you may not have received payment for the product or service in that year, you've either sent the final product to the customer or completed the service.

If you have product inventory that you keep track of, or raw resources that will turn into products, you may want to use the accrual method in order to adequately account for these products and resources. In general, business owners involved in the production, purchase or sale of merchandise must take an inventory and use the accrual method.(If your gross receipts are $5 million or less, you are exempt from this rule. But you still must keep track of your cost in the items you sell; you can't deduct these costs until the later of the year you sell the items or the year you pay for them.)

Hybrid Method

This is a combination of the cash and accrual accounting methods. Sales and inventory are reported using the accrual method. All other items of income and expense are reported using the cash method.

Changing Methods

Once you choose an accounting method for your small business, you can't change it without permission from the IRS. To change accounting methods, contact a tax professional or see IRS Publication 538, Accounting Periods and Methods.