Accrual basis accounting is one of two accounting methods of keeping track of your business’s income and expenses. Cash basis accounting is the other commonly used accounting method.
The third method is a combination of the two and appropriately called theHybrid method.
Most small businesses (with sales less than $5 million per year) are free to choose which bookkeeping method they want to use.
Basically, the key difference between these two accounting methods is the timing of when your transactions (sales and purchases) are debited or credited to your accounts.
Accounting Basis Accounting Vs. Cash Method:
Many small businesses that do not have to keep track of inventory …use the cash basis method. Under the cash method, you do not record your income until cash (or check) is actually received from your customer or affiliate, and business expenses are not recorded until you actually pay for them.
For example, you own a heating and air business, and you repaired a heating system in December but didn’t actually receive any payment from your customer till sometime in January…that sale would not be recorded on that year’s books even though you finished the job at the end of the year in December…it would be recorded in the next year’s books when you actually received a check for that invoice.
Expenses are recorded when the expense is actually paid … usually, this is the date of the check, but there is an exception to that rule. According to the SBA (US Small Business Administration), if you write a check for an electricity bill in December 2019, but the check is not deducted from your bank account until January 2020, you would record the expense for the 2020 tax year.
Important: When using the cash method of accounting, remember to simply expense items used in your business as purchases as you do not maintain inventory when using this method. Nor do you have to keep track of accounts payables or accounts receivable.
Accrual Basis Accounting Method:
Under the accrual method of accounting, income is counted and recorded when the sale occurs, and expenses are recorded when you receive the goods or services. One of the disadvantages of this method is that it does not provide any indication of cash flow. Two other drawbacks are the complexity of the bookkeeping process and the inaccurate picture of the small business’s short-term situation and financial health.
Accrual basis accounting is more widely used among “bigger” small businesses…especially those with inventory and those who extend credit to their customers. A business’s financial statements can only be audited if using the accrual method.
It gives them a better picture of how their business is actually doing.
For example, your business finishes a service job in December and doesn’t get paid until February of the next year, under the accrual accounting method, you would record the sales amount in December….a more accurate picture of your financial situation. Since you don’t have the money yet, the amount would be recorded as an account receivable.
Also, if you order some merchandise to sell in your store, under the accrual basis accounting method, you would record the merchandise as inventory when it arrives, and if you pay for it a month later, it is accounts payable until you pay for it. It does not become a cost of goods until you sell the merchandise…before the sale, it is still considered inventory.
Hybrid Method:
Some small businesses use a hybrid accounting system. In this system, you can generally use any combination of cash, accrual, and special methods of accounting if the combination clearly reflects your income and you use it consistently and follow all accounting principles and GAAP guidelines. There are some restrictions to using this method. See IRS Publication 538 for more details.
Small business owners that are required to use the accrual method to account for inventories but prefer to use the cash accounting method for all other income and expense items may use the hybrid accounting method.
Above I stated that most of the time, you are free to choose which accounting method you want to use; however, there are a couple of exceptions.
You must use the accrual basis accounting method if:
- You have sales of more than $5 million per year, or
- You stock an inventory of items you sell to the public, and your gross receipts are over $1 million per year.
If you later decide you want to change your accounting method, you will need the IRS’s approval. You request approval by filing a Form 3115, Application for Change in Accounting Method. You will need to have sufficient justification and documentation to support the change you are requesting.
References:
SBA:Cash vs. Accrual Accounting for Taxable Income and Expenses