Which accounting method is best for small business?

Starting a new business is exciting, and as a responsible entrepreneur you're diving into the details of good accounting practices. What a smart move! Getting educated now will save you both time and money down the road.

Here’s the big question: Which accounting method is best for your small business?

Let’s break it down by looking at a few important things to consider:

1. The difference between cash and accrual accounting

2. What the IRS expects from you

3. The costs of implementing each method

4. Tax planning opportunities

5. The possibility of switching methods in the future

   
   

Let’s start with the first question: What’s the difference between cash and accrual accounting?

Cash Basis Accounting is straightforward. You record income and expenses when cash actually changes hands. This means no tracking of things like Accounts Receivable or Accounts Payable—just the money that’s in or out of your bank account. For example, if you receive a big prepayment in December 2023 for a marketing project, you’d record it as income in 2023. However, if you don’t start working on the project until January 2024, your business expenses related to the project would show up in 2024. This could make it look like you made a lot of money in 2023, but then had a loss in 2024 due to the associated costs. In reality, though, your profit is the difference between what you earned and spent, but the cash method can make it tricky to see that true picture because the income and expenses are split between two years.

Now, here’s where Accrual Accounting steps in. With accrual accounting, you record income and expenses when they actually occur—whether or not the cash has been received or paid. This method gives you a clearer picture of your business’s financial health. Using the same example: that prepayment from December 2023 wouldn’t show up as income until 2024, when you start working on the project and incur expenses. So, your 2024 financials would reflect both the income and the business costs, and the difference would give you a more accurate picture of your net profit.

Now, moving onto the second question: What are the IRS requirements on methods of accounting?

Well, the IRS’s stance on this question is quite simple: whatever floats your boat. We don't care what you do with your internal accounting and how you track your profits; we only want you to be consistent with your accounting method on your tax returns. If you picked cash basis accounting on your initial tax return, please continue to file as a cash basis taxpayer in the future. If you picked accrual basis as your accounting method on your initial tax return, please don’t switch back to the cash method on the next tax return without talking to us. The IRS is only concerned about collecting tax. And to properly assess tax, they need to see tax returns on the same method of accounting from year to year.

What does this all mean for a small business owner?  Well, this means that the owner can decide what they need for themselves. They can go with the accrual method because they want to see a better picture of their profits. Or they can stick with the cash basis because it is of lesser maintenance. Of course, sometimes companies are required to be on the accrual basis. This could be because they are owned by investors and must show investors their financials on the accrual basis. Or the business must be on accrual due to other regulatory requirements, grants, or state requirements. But this requirement does not come from the IRS. The IRS only wants you to be consistent in your tax reporting. The IRS does have a rule that companies with big gross receipts (over 27 million) should be filing their taxes on the accrual basis. But if you are a small business, this rule does not apply to you.

In many cases, a company may have two sets of books – accrual and cash basis. This way, the company can measure its performance internally by the accrual method, but file tax returns on the cash basis. Or vice versa, the company is allowed to file tax returns on the accrual method, but for their own accounting, they can prefer cash basis financials. That's why many accounting software platforms give you an option to print financials on both cash and accrual basis. It does not necessarily mean that accrual accounting is done correctly, but the option to pull financials on the accrual basis is available.

Now let's move to accounting costs:  Cash Basis Accounting is simple. Here's how it works: whatever money you bring in during the year counts as income, and whatever you spend on business expenses in the same year is your expense. The difference between your income and expenses is your net profit. Simple, right?

For small businesses just getting started, cash basis accounting is easy to manage. You can track it in Excel or even on paper—no fancy accounting skills required (just a basic formula). Most new business owners use this method without needing professional help, which is great for saving money in the early stages.

So, what about accounting costs? If your business is a side gig and you don’t have complicated transactions, you might not need to hire an accountant right away. This method allows you to keep things simple and cost-effective. However, as your business grows, you might need to consider bringing in an accountant to keep everything on track, especially if your business becomes more complex.

Now, let's talk about Accrual Basis Accounting, which is a bit more complex. This method involves tracking invoices and matching revenues to the exact moment they are earned, and expenses to the time when they’re actually incurred. In other words, it's about timing—getting the details right can be tricky. I’ve yet to meet a small business owner who has completely mastered accrual accounting on their own.

Accrual accounting requires a deeper understanding of finances and takes more time. As a result, you'll likely need to hire an accounting professional. You’ll also need more sophisticated accounting software, which can add additional costs.

So, why bother with accrual accounting? Cash basis accounting is easier and cheaper, especially for small businesses with tight budgets in the first year. But keep in mind that it may not give you the full picture of your business's profitability.

Do you need accrual accounting to accurately measure your profit? Not necessarily. Many businesses, like a small produce store, deal with quick cash exchanges and have short payment cycles. In cases like these, the profit figures from both methods would be nearly identical.

Now let's talk about tax planning opportunities for both methods:

Accrual-basis taxpayers have a few ways to manage their taxes effectively. They can time expenses to lower income in high-earning years and defer income on advance payments until they’re actually earned. They’re also allowed to deduct year-end bonuses if paid within the first 2.5 months of the new year. They can also write off bad debts as soon as they’re determined uncollectible.

Does the cash basis lack tax planning opportunities? Not really. Cash basis taxpayers can also time income and expenses to manage their taxable income. For example, they might delay sending invoices until the new year to defer income or prepay expenses, like rent or supplies, before year-end to increase deductions. For example, if the same marketing professional we mentioned earlier receives a prepayment in 2023, they can hurry up and pay for their project expenses in the same tax year (2023). This would mean that their gross receipts and expenses would be shown on financials of the same tax year and they would net each other out and the business owner would pay less tax for 2023 tax liability.

The cash method also has another selling point. It is compatible with individual tax returns (Schedule C on form 1040). When small businesses start out, they, in most cases, start with the Schedule C on form 1040, which is very easy to follow if you are a cash basis taxpayer. Filing Schedule C is inexpensive; it is included in your personal tax return and does not require a separate business tax return. We talked in detail about Schedule C here. Schedule C follows the same logic as a profit and loss statement that could be recreated on Excel: the IRS form shows profits on top, expenses on the bottom, and arrives at the net profit or loss for the year. This layout is very easy for a business owner to follow and to convert their own profit and loss schedule to Schedule C without any particular challenges.

 Now let’s move to the final question: can I ever switch accounting methods on my tax returns? 

The answer is yes, but you would need to let the IRS know by filing form 3115. The form is quite difficult to figure out by yourself, and you might need to account and pay in advance for all the taxable income that may be triggered by changing accounting methods. Most likely, you would also need to hire a tax CPA to do this tax filing for you.

So, which accounting method is best for small businesses? 

Both accrual and cash methods have their advantages. The cash method is easy to implement and less expensive but the accrual method is more accurate. In my opinion, the business owner needs to look into the way business transactions are structured in order to decide if filing as an accrual tax payer on business tax returns offers more tax planning opportunities. They also need to decide if the accrual method would show a more accurate picture of their profits. If the accrual method does have more benefits, you would need to prepare for a more complex accounting setup and additional costs spent on CPAs and bookkeepers. It is always a good idea to talk over this issue with a tax CPA before filing your first business tax return, even if you file the tax return yourself. Nothing is straight forward in tax. Switching from one accounting method to another on your tax return is a complicated and expensive tax filing procedure.

And now a little bit of self promotion: Our CPA firm specializes in tax planning, accounting, tax compliance and payroll services for S Corp owners. If you ever need help with your accounting, keep us in mind. Feel free to read about our services here.