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Should a Small Business Use the Cash or Accrual Accounting Method?

A desk with an out of focus laptop displaying a bar chart in the background. In the foreground and focused, there are 6 stacks of coins, lowest on the left and highest on the right. A man reaches over the laptop and places 2 more coins on the highest stack of coins. Clearly, when faced with the question of whether to use the cash or accrual accounting method, this business has picked the cash method.

Every business, no matter the size, has to keep a set of books so they know how much money is coming in and how much is going out. There are two accepted ways to keep track of this money. One is called the cash accounting method. The other is called the accrual accounting method. There are pros and cons and tax consequences to each. We’ll explain each method and show whether the cash or accrual accounting method is better for small businesses.

This article is a part of our series on how a small business can set up its first accounting system. Deciding on the cash or accrual accounting method is one of the first decisions you’ll have to make. But there are other accounting-related decisions as well. Our intro article takes you through these decisions. We encourage you to take a look.

But here, we’ll only focus on the cash method vs. the accrual method. Let’s start with the easier of the two—the cash method.

What is the Cash Accounting Method?

The cash accounting method keeps track of your money coming in and going out as they move into or out of your bank account. So, if you send out an invoice for a service you performed, you don’t count the invoiced amount as income until you actually receive the money. If you have a bill to pay, you don’t record the payment in your books until you actually pay out from your bank account.

What are the Pros and Cons of the Cash Accounting Method?

The biggest reason to use the cash accounting method is that it is very simple. What if you send out an invoice and the customer refuses to pay? You won’t have to adjust your books to write off the payment because you never recorded it in the first place. In contrast, if you’re using the accrual accounting method, you’d have to make several entries to show you’ve written off the expected income.

One of the biggest disadvantages of the cash method is that it doesn’t alert you to how much money you expect to receive and how much money you expect to pay out. So, if you’re not careful, you can pay out more money than you actually have in your bank. (The easy fix is to track of your expected receipts and payments with a calendar.)

What is Constructive Receipt and What Are Its Tax Implications?

When you use the cash accounting method, you count a payment as income only when the money hits your bank account. But tax authorities like the IRS also use a concept called constructive receipt to figure out income. Constructive receipt becomes important at the end of a tax year, when you have to decide if a payment counts as income for the year that just ended or as income for the new year.

Under the cash method, you have constructively received money when you have full control of the money. This means that, if you receive a check payment from a customer on December 31 but didn’t deposit the check until January 2, the check still counts as income for the year that just ended. You had control of the money. The IRS won’t care that you chose to hold on to it for a few days before depositing it.

On the other hand, if the customer mails the check on December 31 and you didn’t receive it until January 2, then you didn’t have constructive receipt of the money on December 31. You get to count the money as income for the new year and pay the tax on the income next year.

Here are some other examples of constructive receipt, for a better understanding of the concept.

How Do You Track Your Inventory Under the Cash Accounting Method?

Strictly speaking, you can’t track inventory if you use the cash accounting method. Inventory tracking is better done using the accrual method. But, if you’re a very small manufacturing or retail business in the US, the IRS does let you account for your inventory even if you use the cash method.

You Can Write Off Your Inventory as an Expense Using One of Two Ways

To handle inventory when using the cash accounting method, you write the inventory off as an expense.

According to the Inventory section of IRS Publication 538, there are two ways you can do this:

  1. Treat the inventory as non-incidental materials and supplies (NIMS), or
  2. You can write the inventory as an expense if your existing accounting procedures do not track inventory.

The NIMS method is fairly clear. We’ll explain the exact method in the next section. But we researched a lot of articles on how to use method 2, and it’s still hard to understand.

Under the “existing accounting procedures” method, it seems you’re allowed to expense your inventory right away if your existing accounting procedures allow you to do it. This seems like circular reasoning to us.

Here are two articles using more formal wording to explain the “existing accounting procedures” method. The first article is from a big international law firm called Eversheds Sutherland. The second article is from the big network of accounting firms called BDO. We think both are very reliable sources.

Because the “existing accounting procedures” method is so vague, we recommend you use the NIMS method.

How to Expense Inventory under the NIMS Method

According to the NIMS method, you get to deduct the cost of your inventory as an expense:

  • When you sell or use up that inventory (if you sell or use up only a part of that inventory in the first year and sell or use up the rest of the inventory the next year, then you can only deduct as much as you’ve sold or used up for that same year); or
  • When you actually pay for that inventory

Whichever of the above is later.

Let’s say you buy 10 notebooks to sell for retail. You sell 0 notebooks the first year and you sell 10 notebooks the second year. You pay your supplier for all 10 of the notebooks on December 31 of the first year. Then, you get to deduct the cost of 0 notebooks the first year because, even though you paid for the notebooks, you didn’t sell any the first year. You can deduct the cost of all the notebooks the second year.

But what if you sold 5 notebooks the first year, sold 5 notebooks the second year, and paid your supplier all 10 notebooks on December 31 of the first year? Then you get to deduct the cost of 5 notebooks the first year and the cost of 5 notebooks the second year.

Lastly, if you’re a manufacturing business, you get to deduct right away your labor and indirect costs (e.g. supplies bought to help you make a product but doesn’t go into the product).

Why is It Good to be Able to Expense Your Inventory Quickly?

Here’s something fairly obvious but sometimes we forget: income taxes are taxes on profit.

If you have a retail or manufacturing business, you’ll spend money to buy materials or merchandise. If you make your goods, then you pay for the labor and use the material to make the final goods. Then you add a markup and sell the merchandise. Intuitively, you know that your profit isn’t what you sold the goods for—it’s what you sold the goods for, minus all the costs you paid to buy or make the goods.

Because we only pay taxes on profit, you should get to subtract all your costs from your revenue before calculating your income taxes.

The NIMS rules basically let you do this very common-sensical thing in a simplified way. If you use the accrual accounting method, tracking gets a little more complicated. Mostly because, in the real world, it’s more complicated to figure out your real costs for buying or manufacturing goods. The accrual method sometimes won’t let you subtract your costs right away, when your income taxes are due. (Eventually you’ll be able to subtract all your costs.)

This is why small businesses like the cash method and the NIMS rules under the cash method. It lets you subtract your costs quickly. And it gets you to an accurate income tax number faster.

Can You Use the Cash Accounting Method if You Have a Software Business?

The short answer is, yes, you can use the cash method if you have a software business—specifically a software-as-a-service (SaaS) business. In this case, you build your software and provide services with the software.

When you’re building the software, you can expense the labor costs of building the software as you pay your contractors or employees.

When you start selling services provided under your software, you simply record the revenue as they come in each month. This would be true even when you sell a subscription with a recurring monthly payment.

Often, when a SaaS business is smaller, the cash accounting method can handle the business’s needs. But we recommend you upgrade to the accrual accounting method as soon as you can. There are special rules in the accrual method that let you capitalize your software to reduce your tax payments. You don’t get to capitalize anything under the cash method. With the accrual method, you’ll also be able to more accurately track the subscription earnings and possibly reduce your tax burden.

What is the Accrual Accounting Method and Why is it the Default Accounting Method for Most Businesses?

Unlike the cash accounting method, the accrual accounting method starts to track your income and expenses the minute you send out an invoice or spend the money. You don’t have to have actually received or paid out the money. So, your books will reflect the incoming and outgoing money before you see the change in your bank accounts.

The concept for the accrual accounting method sounds simple, but it has a lot of implications that complicates the way a business keeps its books. Nevertheless, most businesses use the accrual method because it gives the most accurate picture of money in and money out, as well as the business’s total assets and liabilities at any given moment.

The accrual method leads to many items and terminologies commonly associated with accounting. These terms include accounts payable, accounts receivable, depreciation, COGS, etc. We’ll explain these terms in our article on basic accounting concepts for small business owners.

For now, and for this article, just know that these terms are used with the accrual accounting method. If you use the cash accounting method, you won’t have to deal with these terms at all. 

Which is Better: The Cash or Accrual Accounting Method?

Now that you understand a little bit about each accounting method, you’ll naturally want to know whether the cash or accrual accounting method is better for a small business. We give the quintessential frustrating answer: it depends.

If you’re a freelancer or contractor, you operate a service business, and you don’t have other employees, using the cash accounting method is probably the most convenient. This method requires very little formal accounting training and takes very little time to maintain.

You can still use the cash method if you run a very small retail or manufacturing business and/or if you have just a handful of contractors or employees. But if your business expands and you take on more employees or increase your inventory, switching to the accrual accounting method is much better. The accrual method can give you more detailed information about your costs and can tell you where your money is being held up (e.g. you bought too much raw materials). It can also give you a better idea of your expected earnings and payments.

And, if your business is based in the US and you need to pay taxes to the IRS, then the IRS requires you to use the accrual method if your business hits certain revenue limits. There are some details involved and we encourage you to check IRS Publication 538 for the details. But, generally, you can use the cash accounting method if your average annual gross receipts is $26 million or less for the past 3 years (adjusted for inflation). If you haven’t been in business for that long, use only the years you have been in business to calculate your average annual gross receipts.

Otherwise, you must use the accrual accounting method.

Don’t Forget State Requirements

So far, we’ve only talked about how the accounting method you pick can affect your federal income taxes. Most states will also tax a business’s income by simply calling it an income tax. But some states—even the ones without an income tax—impose a franchise tax that is based on a percentage of your business’s revenue. So, you’ll want to make sure your state will allow the accounting method you pick, for the revenue level you’re at.

Fortunately, state tax rules typically follow federal tax rules. Nevertheless, it’s safer if you double check your state’s requirements for your type of business before deciding on an accounting method.

This section applies to you if you’re a business based in the US. If you’re in another country, in addition to checking your country’s tax laws, be sure to check local tax laws like the laws for your state, province, or other governmental unit.

For Now, Pick the Method Convenient to You; You Can Always Change it Later

If you start with one accounting method and you later wish to change to another method, you can do it. You’ll have to file a few forms with the IRS. Hopefully, by the time you feel you should switch, you’ll have money to hire an accountant to help you with the other aspects of your books. They can take care of the IRS paperwork for you.

As to whether we recommend the cash or accrual accounting method, we’re running our business using the cash method for now. But this is only because the bookkeeping software we use only offers the cash accounting method. We actually prefer the accrual accounting method because we like how it gives a more nuanced understanding of a business’ overall financial picture.

If you’re running a small one-person business, a service business, or a very small manufacturing or retail business, it’s probably easier for you to start with the cash method. You might eventually hit that $26 million gross receipts threshold and be forced to upgrade to the accrual method. But we think that, long before you hit the threshold, you’ll have money to hire a CPA who can recommend if and when you should switch.

Interested in starting and running a small business? Here’s the beginning of our step-by-step guide: What to do right after getting that great business idea.

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