Accrual vs. Cash-based Accounting

When it comes to accounting methods for business, two types are generally used: accrual and cash-based. The type of business, style of incorporation or level of sales — and sometimes a combination of those factors — determines which method you use.

Under the accrual method, revenues are recognized at the time the goods or services are sold, which results in accounts receivable. Expenses are recognized when obligations are incurred, which gives rise to accounts payable. “Revenues are incurred when the right to receive payment has occurred and the amount can be determined with reasonable accuracy,” says Phil Christofi, principal at the accounting firm of Christofi & Co., Inc. “In other words, under the accrual method, revenues and expenses may not actually have been received or paid in cash, but are recorded as they’re complete.”

The accrual method is usually used by businesses that produce, purchase or sell merchandise. A company like a manufacturer that carries inventory from period to period and doesn’t sell it immediately is a typical accrual-based business.

The cash method, sometimes called the cash receipts and cash disbursement method or cash in, cash out, is the simpler of the two. In this case, revenues are recognized when cash is received and expenses are paid when they’re incurred. The cash method can also involve “constructive receipt of cash,” which means that you have some type of representative payment in hand, cash or otherwise. “Constructive receipt might mean that you have a deposit to your account and the money is available but you haven’t yet drawn it out,” Christofi explains.

Transaction-based service businesses, like accountants, law firms, architects and physicians, typically use the cash method of accounting.

Determining the Right Method
The Internal Revenue Service (IRS) offers fairly clear guidelines on which method can be used by what type of entity:
• If your average annual gross sales are greater than $5 million for the past three years, you must use the accrual method.
• If your sales are less than $1 million annually, you can use either method.
• If you operate a qualified personal service company, you can also choose between the two.
• If your sales are between $1 million and $5 million, and you operate a service company and not a C Corp., you can also take your choice of methods.

The IRS Revenue Procedure 2000-22 sales test can help you determine whether you can use the accrual or cash method. Under the test, you average your company’s revenues during the previous three years you’ve been in business. If the average revenue is less than $1 million, you can use the cash method at your own discretion, regardless of the type of company you operate (excluding C Corp. companies). The revenue tested includes sales revenue, services, interest, dividends, rents and royalties. Sales taxes are not included in the test. (If you do have to switch methods, you’ll need to file a Form 3115, Application for Change in Accounting Method (PDF1).)

Key Differences
The key difference between the two methods, says Christofi, is simplicity. With the cash method, bookkeeping is much easier, as accounts receivable and payable are not involved, which can make the process less complex for small business operators.

But there are advantages to the accrual method. “It gives you a much better picture of a company’s economic condition,” Christofi notes. “It offers a longer-term view of when funds are coming in and going out. With the cash method, you’re looking at a snapshot in time that shows you basically what the bank account looks like.”

It’s human nature to pick the easiest method, adds Christofi, but you may be doing yourself a disservice in the long run if you don’t choose the right one for your business. “In some cases, with contractors, for example, you’re required to produce financial statements, which is easier to do if you’re using the accrual method, as you’re already producing the accounts receivable and payable information you need,” he says. “On the other hand, if you’re making less than $1 million in sales annually and using the accrual method, you may be paying taxes sooner than you have to when bringing accounts receivable onto the books. The best way to deal with the question is to do your own research and then talk to your accountant or financial advisor about which method makes the most sense for your business.”

Source: Wells Fargo

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