Most small businesses use the cash method of accounting. You record transactions when you receive a payment or when you pay an expense. The main difference between accrual and cash basis accounting lies in the timing of when revenue and expenses are recognized. The cash method is a more immediate recognition of revenue and expenses, while the accrual method focuses on anticipated revenue and expenses. Cash accounting is simple, and it provides a clear picture of your cash flow. Accrual accounting portrays a more accurate portrait of a company's health by including accounts payable and accounts receivable.

Advantages and Disadvantages of Accrual and Cash Basis Accouting When Measuring a Company's Health...

A disadvantage of the cash method is that it might overstate the health of a company that is cash-rich but has large sums of accounts payables that far exceed the cash on the books and the company's current revenue stream. An investor might conclude the company is making a profit when, in reality, the company is losing money.

Accrual accounting gives you a better picture of your company's overall performance. Instead of tracking payment, you are tracking how much work you do during a period that gives you a better picture of the company's health. Accrual account is more timely, a company might have sales in the current quarter that wouldn't be recorded under the cash method because revenue isn't expected until the following quarter. An investor might conclude the company is unprofitable when, in reality, the company is doing well.

Cash accounting requires less work and allows you to spend less effort on bookkeeping. It allows you to see what you have immediately. You can see your cash flow at all times. You will always know your bank balance.

The disadvantage of the accrual method is that it doesn't track cash flow and, as a result, might not account for a company with a major cash shortage in the short term, despite looking profitable in the long term.

There Is An IRS Requirement for Accrual Accounting

Businesses with inventory must use the accrual method. Inventories are necessary for most marketing, manufacturing, retail, or wholesale businesses. C corporations with average annual cash receipts over $5 million that are not personal service corporations generally must use the accrual method. What type of business is exempt from using the accrual basis for accounting? In addition, under the general rule for methods of accounting in Sec. 446, the accrual method is generally not required for businesses in which the sale of inventory is not a material income-producing factor, as long as the use of the cash method clearly reflects income and is consistently used.

House Ways and Means And Tax Reform Changes May Be Coming

Once a business earns more than $10 million annually it is generally required to switch to accrual. This requirement may change. If the law changes many businesses may have to switch to accrual accounting. If your company is an S-corporation a personal services corporation or a farm operation you may want to talk to a professional accounting service about how these changes might affect your company.

Both methods have their advantages and disadvantages, and each only shows part of the financial health of a company. Understanding both the accrual method and a company's cash flow with the cash method is important when making an investment decision.

 

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