For companies required to comply with GAAP standards, the accrual-basis method is the preferred form of accounting. Simplicity can work for individuals or very small businesses, but not as much as a company expands. Therefore, it might make sense for a small business to start with the cash-basis approach and switch when the company requires greater accountability. Note that the net income from the income statement carries over to the cash flow statement, and the cash at the end of the year on the cash flow statement matches the cash figure on the balance sheet. Note that corporations with average annual revenues of over $26 million for the previous three tax years must use accrual accounting. To further complicate the situation, once you choose, and file taxes using your chosen method, you will need to request approval from the IRS to change the accounting method that your business uses.

We believe everyone should be able to make financial decisions with confidence. Learn what outsourced accounting involves, its advantages, and whether or not it’s right for you. In addition, because many businesses end up needing to switch over to the accrual method as they grow, or because they want to take on investors, it can make a lot of sense to start with accrual from the outset. As a business owner, you want to avoid “accounting hindsight,” which is when you unintentionally overestimate an accounting-related outcome that you could have predicted before it occurred.

What is the accrual accounting method?

For investors, it’s important to understand the impact of both methods when making investment decisions. The vasty majority of companies that people would potentially invest in, will be using accrual-based accounting. However, should you come across a small company using cash-based accounting, it’s definitely something to watch out for. Accrual accounting has cash basis accounting measures income based on accounts receivable (A/R) and accounts payable (A/P) in financial statements, which inform you of what payments you will receive and your outstanding bills. While there are some drawbacks to using a cash basis income statement system in modern procurement practices; small businesses with limited resources often benefit from its simplicity and ease-of-use.

Cash basis accounting is relatively easy to use and maintain, which makes it an attractive option for small business owners and individuals without extensive accounting knowledge. They can track their financial transactions based on cash inflows and outflows without the need to track accounts receivable or payable. The difference between cash and accrual accounting lies in the timing of when sales and purchases are recorded in your accounts. Cash accounting recognizes revenue and expenses only when money changes hands, but accrual accounting recognizes revenue when it’s earned, and expenses when they’re billed (but not paid).

Products and services

Without forecasting and completing a comparative analysis, you might assume you’re in a profitable spot without accounting for the past decline in sales and a slow-to-steady fall. However, the cash basis method might overstate the health of a company that is cash-rich. That’s because it doesn’t record accounts payables that might exceed the cash on the books  and the company’s current revenue stream.