Cash Method of Accounting vs. Accrual Method

Accounting is an essential part of any business, as it helps to keep track of finances and ensure that a business is profitable. Two of the most common methods of accounting are the cash method and the accrual method. These are sometimes called cash basis accounting or accrual basis accounting. While both methods have their benefits and drawbacks, it's important to understand the differences between them in order to choose the best method for your business. Additionally, the type of entity that you have can dictate which method of accounting you are allowed to use.

Cash Method of Accounting

The cash method of accounting is a simple way for businesses to track their money based on when cash is received or paid out. It's a good option for small businesses and individuals who want a clear picture of their cash flow.

Here's how it works: if a business provides a service to a customer and the customer pays on the spot, the revenue is recorded right away. Likewise, if a business purchases supplies and pays for them with cash or a check, the expense is recorded at that moment.

One of the benefits of the cash method is its simplicity. It's easy to understand and doesn't require fancy accounting software or a degree in accounting. Plus, it gives a clear picture of how much money is coming in and going out of the business.

However, the cash method does have some limitations. One major drawback is that it may not provide an accurate picture of a business's overall financial performance because it only recognizes revenue and expenses when cash is received or paid out. This means that revenue or expenses that have been earned or incurred but have not yet been paid or received will not be accounted for until the cash is exchanged. For example, revenue from services provided in one month but not paid until the next month would not be recognized until the payment is received.

The IRS has specific guidelines as to which types of entities are eligible to use the cash vs. accrual method and many small businesses do qualify. Most corporations are not permitted to use the cash method, though the cash method may be used by certain farming or timber businesses, qualified personal service organizations, and businesses that pass a $29 million gross receipts test. S-Corps and LLCs, on the other hand, are frequently permitted to use the cash method. 

Accrual Method of Accounting

On the other hand, the accrual method of accounting recognizes revenue and expenses when they are earned or incurred, regardless of when cash is received or paid out. This means that revenue from services provided in one month but not paid until the next month would still be recognized as revenue in the month it was earned. The same goes for expenses, such as supplies purchased on credit that won't be paid for until the next month.

One of the benefits of the accrual method is that it provides a more accurate picture of a business's financial performance over time. This can be especially important for businesses that have long-term contracts or delayed payments. It can also provide a more accurate view of profitability and help businesses better understand their financial trends.

That said, the accrual method can be more complicated and time-consuming to implement than the cash method. It requires a greater understanding of accounting principles and software, and it may require more frequent bookkeeping and record-keeping to ensure accuracy. Additionally, it may not provide as clear a picture of a business's current cash flow.

How to Implement Cash or Accrual Method

Most (if not all) bookkeeping or financial business software will allow you to select which type of accounting you'd like to use for your business. In fact, many of the most popular software products will allow you to switch from one to the other if you change your mind or your business becomes ineligible for the cash method.

In Quickbooks, this is found under Settings > Account and Settings > Advanced (tab). Select Edit and choose your accounting method and click save.

Additionally, most modern accounting and bookkeeping software will allow you to view reports in either cash or accrual method so it's easier than ever to maintain a complete understanding of your business's financial picture. 

Overall, the cash method of accounting is a simple and easy way for businesses to track their money based on when cash is received or paid out. It's a good option for small businesses and individuals who want a clear picture of their cash flow. However, it may not provide a complete picture of a business's financial performance. The accrual method, while more complex, provides a more accurate picture of a business's overall financial performance.

Ultimately, the choice between the two methods will depend on the individual needs and goals of the business. It's important to consult with your accountant to determine which method is best for your business.