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There isn’t a one-size-fits-all approach to accounting—and choosing the right method for your business can be tricky. 

Typically, business owners choose between cash basis and accrual accounting. This choice will influence a wide variety of business functions, including taxes. If the company goes public, the chosen accounting method will also affect quarterly and annual reporting.

While there are arguments to be made for both methods, let’s explore why cash basis accounting might be right for your business.

What is cash basis accounting?

Cash basis accounting records expenses as revenue only when your business receives payment. By contrast, accrual accounting allows you to record those expenses on the day you’ve completed the sale or received a purchase agreement.

 

Cash basis accounting tends to be simpler for small business owners. They may not have the time or inclination to carry out complex bookkeeping, planning, and data entry. With cash basis accounting, a business owner makes fewer decisions while recording expenses and income. The date of the actual payment entry is the date the money goes in or out.

How your accounting method impacts your taxes

A company declares its accounting method on its first tax return. A selection box on the proper form (Schedule C for individuals and sole proprietors, for example) is used to indicate the use of the cash or accrual method. There's no rule on which one you have to use, but the IRS stipulates that "You must use a system that clearly reflects your income and expenses and you must maintain records that will enable you to file a correct return."

The accounting method must apply to both income and expenses. However, the IRS does allow you to use different methods for different items, for example, business versus personal items.

Corporations can use the cash method if they're S corporations, or if they meet the gross receipts test: average annual gross receipts of $26 million or less over the past three tax years. Any larger businesses must use accrual.

Qualified "personal service corporations" can also use the cash method. A PSC is a C corporation in which employees/partners licensed in such fields as health, law, and engineering provide their services to the public.

Changing the accounting method is possible, but your business must file Form 3115 and be qualified by the IRS.

How cash basis accounting impacts your fiscal year

The choice of fiscal or tax year is important. Some business owners simplify matters by matching their fiscal year to the calendar year. If your company has set up a different fiscal year (July to June, for example), then your cash method accounting must also shift to align with this date range.

For a service business such as a lawn care company, annual contracts are a common way to engage new customers. In an accrual business, a $12,000 two-year contract signed in July is fully booked as (taxable) income in the year the deal is signed. But if monthly installments are accepted for payment, a cash-method business pushes this income to the year when the money is actually received.    

Advantages and disadvantages of cash basis accounting

Besides the relative simplicity of the cash method, businesses using it don't need to deal with separate "accounts payable" or "accounts receivable."  Sales and expenses can be tracked in a single place on your accounting software, reducing the chance of mistakes or confusion.

The downside is a loss of accuracy when analyzing cash flow. A cash-method business may not have a great handle on why its cash on hand varies so much from one month or season to the next, or whether steady customers are consistently late with their payments. In addition, lenders may want more precise details on business activity for each quarter. Without that information, a business may find it tough to secure loans needed to stay afloat.  

The accrual method is useful for larger businesses, as it gives a more accurate cash-flow picture over a given period. Sales made in a quarter, for example, are recorded for that quarter whether or not the proceeds arrive the same day or months later. In this way, sales numbers (and other numbers, including expenses, taxes, and interest payments) more accurately reflect business activity.    

Simplify your accounting with Ramp’s automation tools

While your accounting method of choice has a huge impact on your business, choosing to (or not to) leverage automation can be just as critical. 

Ramp has designed its expense management, bill payment, and accounting automation tools to save your business time and money. These tools reduce the amount of time spent on tedious tasks, freeing up your team to focus on more strategic finance initiatives—including choosing the right accounting method for your business.

Want to learn more about how Ramp can simplify your accounting? Click here to get started.

Try Ramp for free.
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Finance Writer, Ramp
Richard Moy has written extensively about procurement and vendor management topics for companies like BetterCloud, Stack Overflow, and Ramp. His writing has also appeared in The Muse, Business Insider, Fast Company, Mashable, Lifehacker, and more.
Ramp is dedicated to helping businesses of all sizes make informed decisions. We adhere to strict editorial guidelines to ensure that our content meets and maintains our high standards.

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