Cash vs. Accrual and Why Accounting Matters for Taxes

This article is a reprint of Wise Bread's contribution to OPEN Forum from American Express -- where small business owners can get advice from experts and share tips with each other.

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When you're running a small business, it may seem like deciding between cash and accrual accounting is just one more thing on the long list of things you need to get done. But the fact of the matter is the decision on which accounting method you're going to use makes a difference in something as simple as how you do your taxes and can have long-lasting effects beyond the end of the year.

The Difference Between Cash and Accrual Accounting

The cash method of accounting is the most common choice for small business owners. Under the cash method, you don't count income until you have the cash or the check in hand and you don't count expenses until the money leaves your account. In comparison, under the accrual method of accounting, you record transactions when they happen, no matter when the money actually changes hands. The cash method tends to more popular because it's easier for many businesses to keep track of. But if there's a lengthy delay between when you do work and when you receive payment, some issues can occur.

There are some situations in which your business absolutely must use the accrual method. If you have sales of more than $5 million per year or your business maintains an inventory of items you sell to the public and your gross receipts total more than $1 million per year, you're required to use the accrual method.

Paul Miller, a professional juggler who just happens to have a degree in accounting, chose the accrual method in an industry — entertainment — that tends more towards the cash method. His choice was based on the fact that it's easier to tell where your business' finances actually are with accrual accounting, rather than just knowing what cash you have on hand. Miller says:

I selected the accrual method for more accurate reporting. Many of my receivables are paid net 30, net 60 and sales as a whole are very dependent on the month of the year. I will earn $20-30,000 from library and camp work in August and much of it won't be paid until September. Most of this income in September will be from school and after-school programs. By using the accrual method, I can get an accurate picture of how much I earned each month and from what sources.

Using Accounting to Manage Taxes

One of the biggest changes a choice in accounting methods can create is how you handle tax deductions. Under the cash method, if you make a purchase in 2010 but don't send payment until 2011, you won't be able to deduct that expense until 2011. Under the accrual method, however, you would be able to claim the deduction in 2010. That may sound like a subtle difference, but depending on your business' expenses and income, it can be quite complex.

For instance, if you often have long periods between the point when you make a sale and when you receive payment, the accrual method can actually cause some problems. For instance, you may send out an invoice at the end of December, but not receive payment by the time you need to send in your tax return. If you're using the accrual method, you're still expected to pay taxes on that expected income, although it isn't in your bank account yet.

There are certain situations in which the system of accounting that you choose will play a more minor role. Dick Barnes has operated several small businesses over the years and is now a partner with the Freeland Group, a management consulting firm. Barnes says:

If cash accounting shows too much profit one year, it will likely show too little the next and vice-versa. An example of a difference might be if using long-term debt with a single balloon payment and you write-off the entire debt load in a single year (kind of dumb normally, unless you're having an extraordinary year).

Making the Switch Between Accounting Methods

As a small business owner, you're likely already using one accounting method or the other. But just because you've been using a particular method in the past does not mean that you cannot switch to the other. Barnes suggests talking to your accountant, especially if you're moving from the cash method to the accrual method.

Depending on the type of business, the switch could be very simple...or it could be pretty complex." Barnes points to certain issues that may slow down the switch: if you already have a commercial line of credit, where your accounts receivable stand and how long your operating system is.

If you're the one keeping the books for your company, you may need to pick up a few new skills if you make the switch to accrual accounting. Miller says:

I do think that an attentive small business owner can pick up the steps to run an accounting system based on the accrual method. It is mostly a case of reporting and a couple of extra accounts.

Your CPA may even be willing to walk you through the differences, especially if you're using common software, such as Quickbooks.

Beyond Taxes: Make Sure You Have Room to Grow

Your accounting method isn't just a matter of doing your taxes. Barnes has owned a number of small businesses and, as a business owner, preferred the simplicity of cash accounting. But when he changed tracks, he realized how important it was for small businesses to use the accrual method when possible:

As a commercial lender, I found that cash accounting makes it difficult to verify or judge what the firm is actually doing at any one point in time. Most banks will not consider putting together a loan package with cash accounting financial records, particularly if the firm grows beyond the $500k annual revenue level. They simply want the owner to go back to the blackboard, hire a CPA for accuracy, and come back with what they often call 'legitimate' financials (accrual).

If you think that, down the road, you may need capital to expand your business, it's important to make sure that your accounting method won't get in the way of you getting a loan. Barnes suggests meeting with your bank long before you ever need a loan to check what your options will be with the bank that already has your business; ask your banker if the bank would have a problem with cash accounting if you ever ask for a line of credit.