and Luke Palmer
Owning a business requires you to make countless decisions day in and day out, especially when you’re just getting started. One decision every business owner has to make is which basis, or method, of accounting to use. (Per the IRS, all taxpayers must determine their taxable income within an annual accounting period—that is, a tax year—using a consistent method.)
The accounting basis you choose could impact your business’ cash flow as well as its tax liability. For these reasons, it’s important to choose wisely. Thankfully, you have two primary options to choose from: the accrual basis or the cash basis.
To help you make the right decision for your business, here’s a quick summary of each.
Accrual basis of accounting: What to know
Under the accrual basis of accounting, transactions are recognized and recorded in the period that the transaction occurred—not necessarily in the period the cash was transferred. For example, if your company were to issue an invoice to a customer on December 31, 2024, you would record the increase to accounts receivable and the sales revenue in 2024, even though the cash would be received in 2025.
The same goes for expenses and liabilities. If you receive an from a vendor invoice for expenses, you record the invoice in the year it was received. So, if you received the invoice on December 15, 2024, this is when you’d record it in your books. If you paid the invoice on, say January 15, 2025, you’d record the payment between your cash account and your accounts payable account in the year you paid it.
As you can see, the accrual basis allows you to always have a clear financial picture of your company, as you are tracking income and expenses as they occur. This can help you identify trends, analyze your business’ performance, and better understand how and where to allocate your resources and plan ahead for upcoming expenses.
If your business involves inventory, accrual accounting allows you to track the cost of goods sold (COGS) more accurately. This is crucial for calculating profitability and making informed decisions about inventory management. If you need financial statements to provide to your bank or surety, your books would need to follow the accrual method, per Generally Accepted Accounting Principal (GAAP) reporting requirements.
Cash basis of accounting: What to know
Under the cash basis of accounting, transactions are recognized and recorded in the period that the cash is paid or received. In the previous invoicing example, the transaction would be recognized and recorded in the period that the cash was paid in 2025, not in 2024 when the invoice was issued.
Here’s another example of using the cash vs. accrual basis: Let’s say you paid your December 2024 insurance in January 2025. Under the accrual method, this expense would be eligible for deduction in 2024. Under the cash method, the deduction would be recognized in 2025.
The cash method is often suitable for smaller companies that do not have large amounts of accounts receivable, accounts payable, or inventory to track.
However, not every business is permitted to use the cash method; businesses are subject to a annual gross receipts test in order to be eligible to use it. If a business’ average annual gross receipts for the three preceding tax years exceeds $30 million, the business is required to use the accrual basis of accounting for their tax return reporting.
What about your tax reporting?
As long as your business falls under the aforementioned $30 million threshold, you can choose to use either method for your tax reporting; you do not have to use the same reporting for your books as you do for your tax return.
If your company is eligible to use either basis for tax reporting, consider which is most tax advantageous or fits best with your tax strategy.
For instance, if you were to select the cash method, your tax strategy could involve paying down accrued liabilities at the end of the year, so the expense could be taken in the current tax year.
Keep in mind that for financial statement reporting (compilations, reviews, and audits), you are generally required to report under the accrual basis of accounting no matter what. You could still use the cash basis of accounting for your tax purposes, but you cannot use it for your book purposes.
Once you choose an accounting method, you aren’t locked into it; you can change it by filing forms with the IRS. That said, it’s best to switch within your first two years of operations to avoid extra paperwork and the potential for tax consequences.
Make the right choice for your business
If you’re trying to decide between the accrual or cash basis of accounting, consider which one makes the most sense for your business’ operation cycle.
Thankfully, this is not a decision you have to make on your own: JAK + Co. can guide you through it. We can assess your business’ needs and advise you on which basis of accounting is best. If you need to make a change in your accounting method, we can help you do so when that time comes and walk though through the necessary steps and filings that are needed.
To learn more about how JAK + Co. can guide you through your daily decisions, contact us today.