Cash versus accrual accounting method - which is right for me?

There are basically two methods of accounting expenses and income. One is cash basis and the other is accrual. The difference between the two is basically time. With the cash system you only account for an expense or earning when you actually get the money or pay it not when you accrue the sale or expense. This can get inaccurate when you are paying with credit or other ways to prolong the payment or if you use a collection service to do your accounts receivable you only count income when it actually hits your account not when you have done the service or given the product.

Here is an example of each type of system
Cash
On November 30th, 2006 your small business sells 100 Lord of the Rings video games for $100 each. But the person buying the Lord of the rings video games doesn't send the check until Jan 1, 2007. On the cash system you don't list the $10,000 as income for taxes until you file your 2007 taxes.

Accrual
On Novemeber 30th, 2006 you sold 100 Lord of the rings video games for $100 each and list that on your November income. You also list it on your 2006 taxes even though you don't actually get the money until Jan 1, 2007.

The time factor can really affect the appearance of your business, if for example you have several large accounts pay for goods you bought on credit and you won't pay for the goods until the next month than using the cash system can make it appear your business is in the black when in reality the goods will put you back in the red.

The three most common reasons the IRS would make you use the accrual system are your business's gross receipts have grown to exceed $5 million this year, or you recently changed the structure of your business to a C corporation, or lastly you started a new division that requires your business to keep an inventory. Any of these things and a few others would make it so you have to use the accrual method.

Most people naturally do the cash basis of accounting especially for personal finances. But as many have found out the hard way just because you still have checks doesn't mean you have money to cover them. Mostly the cash system is a chase system where you try to beat the expenses before they come through. Not a good way to run a business.

Accrual can be more expensive because it generally requires an accountant. But it is also more accurate so could be worth the expense of hiring a professional because you are trying to paint an accurate picture of your business's worth for investors or a bank for loan purposes. Most accountants and bankers will be more respectful of a business statement with the accrual system because it paints a more accurate picture of the true financial health of the business.

Most successful businesses hire accountants and use their expertise to calculate using the accrual system for their business. This extra cost factor sometimes prevents businesses from using this method of accounting. There are two types of businesses that benefit from a cash system that is Doctors who don't always get paid for their services and Agricultural businesses like ranchers or farmers who don't always bring in the revenue do to weather or other unforeseeable events. These two businesses would do well to talk to an accountant about the best method of accounting for their particular business type.

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