Accounting Methods

The accounting method you choose determines when you record income and expenses. This fundamental decision affects your financial statements, tax obligations, and business insights.

Two Main Methods

Cash Basis Accounting

Definition: Record transactions when cash changes hands.

Characteristics:

• ✅ Simple and straightforward
• ✅ Shows actual cash position
• ✅ Easier for small businesses
• ❌ Doesn't match revenue with related expenses
• ❌ Can distort true financial picture

Example:

January: Perform $5,000 service, receive payment in March
Cash basis: Record $5,000 revenue in March (when paid)

Accrual Basis Accounting

Definition: Record transactions when they occur, regardless of cash movement.

Characteristics:

• ✅ Matches revenue with related expenses
• ✅ More accurate financial picture
• ✅ Required for larger businesses
• ✅ Better for decision-making
• ❌ More complex to maintain
• ❌ Can show profit while being cash-poor

Example:

January: Perform $5,000 service, receive payment in March
Accrual basis: Record $5,000 revenue in January (when earned)

Detailed Comparison

Aspect	Cash Basis	Accrual Basis
When to record revenue	When payment received	When earned
When to record expenses	When payment made	When incurred
Complexity	Simple	More complex
Accuracy	Less accurate over time	More accurate
Tax implications	May delay tax liability	Matches economic reality
Best for	Small businesses, sole proprietors	Growing businesses, corporations

Modified Cash Basis

A hybrid approach that:

• Uses cash basis for most transactions
• Uses accrual basis for specific items (e.g., long-term assets, inventory)
• Provides middle ground between simplicity and accuracy

Choosing Your Method

Use Cash Basis If:

• You're a small business or sole proprietor
• You don't carry inventory
• Your annual revenue is under $25 million
• You want simplicity
• Most transactions are cash-based

Use Accrual Basis If:

• You're a corporation or partnership
• You carry inventory
• You have significant receivables/payables
• You need accurate financial statements
• You're seeking investors or loans

IRS Requirements

The IRS requires accrual basis accounting if:

• Your average annual gross receipts exceed $25 million (for 3 prior years)
• You're a C Corporation or partnership with C Corp partners
• You maintain inventory (with some exceptions)

Important

Once you choose an accounting method, you can't switch without IRS approval (Form 3115). Choose carefully!

Real-World Impact

Scenario: Small Consulting Firm

Cash Basis View:

December: Performed $10,000 service
January: Received $10,000 payment

December P&L: $0 revenue
January P&L: $10,000 revenue

Accrual Basis View:

December: Performed $10,000 service
January: Received $10,000 payment

December P&L: $10,000 revenue
January P&L: $0 revenue (already recorded)

The accrual method better reflects that the work was done in December, even though cash was received in January.

Special Considerations

Inventory

If you sell products and maintain inventory, you generally must use accrual accounting for purchases and sales, even if you use cash basis for other transactions.

Long-Term Contracts

Special rules apply for construction and other long-term contracts. The percentage-of-completion method may be required.

Professional Services

Many service businesses can choose either method, but accrual provides better management information as you grow.

Practical Tips

1. Start simple: Most small businesses begin with cash basis
2. Plan for transition: Know you may need to switch as you grow
3. Consider your industry: Some industries favor one method
4. Think about financing: Lenders prefer accrual-based statements
5. Consult professionals: Get advice before making your choice

Software Considerations

Modern accounting software can handle both methods:

• QuickBooks: Supports both cash and accrual reporting
• Xero: Primarily accrual-based
• FreshBooks: Designed for cash-basis users
• Wave: Supports both methods

Many systems allow you to toggle between cash and accrual views for reporting purposes.

Next Steps

Understanding accounting methods prepares you for learning about the bookkeeping cycle — the step-by-step process of recording and reporting financial information.