There are 2 main methods for tracking the expenses and revenues for your business that are accepted by the IRS. Which one you use depends on the type of business that you have, what your goals are, and how you use your financial data.
So how do you know which method is best for you? The IRS makes you to select a method the first time you file your taxes and that is the method you will continue to use for taxes for the life of your business. Even after you’ve made this decision, you have some leeway on which method you use for internal purposes.
There are a few important things that you should consider before you make this choice. Each method has its benefits and drawbacks which I have outlined below. Take the time to understand how each method can affect your business and make the decision that is right for you.
Accrual Method
This accrual method means that revenue and expenses are recorded when they are earned or used.
For example, say you perform a service for a client in Jan. The client pays the invoice in Feb. Under accrual accounting, you would record the revenue in January since that is when it was earned.
The accrual method provides a far more accurate vision to profitability as you can easily compare a month’s revenue with the same month’s expenses to determine actual profit margins. You can easily see if your expenses are too high or if your profit margins are too low and make any necessary adjustments. If you intend to grow your business or use your books to make business decisions, then the accrual method is the way to go.
Unfortunately, accrual may be too convoluted for entrepreneurs to track themselves if they don’t have basic accounting knowledge. There are a lot of items that will need to be modified monthly and will require adjusting journal entries within the accounting software. This is often better left to professionals to avoid errors. It is also harder to track your cash flow; however, this issue can easily be remedied by pulling a Statement of Cash Flows report on a monthly basis.
Some businesses are required by the IRS to follow the accrual method. Those include:
C Corporations
Any business with inventory
Gross sales revenue more than $5 million (Some exceptions apply)
Cash Method
Entrepreneurs that do their own books are most likely using the cash basis. The cash basis is accounting for income and expenses when they are paid or received. At its most basic level, the cash method tracks your cash only as it moves in or out of your business.
Let’s use the same example of above. Under cash accounting, you would record the revenue in Feb since that is when you received the actual payment.
The cash method is a very simple to maintain for those doing their own books so it’s tempting to choose this method based solely on level of ease. You can link up your bank feeds in the accounting software and classify everything when the cash moves in or out of the account without worrying about adjusting journal entries.
The hidden cost of this simplicity is that you don’t have a good view of your profitability. Your revenues and related expenses aren’t easily matched up so you will have a more difficult time using the financial data to make business decisions.
Based on this, the cash method is generally best for very small or micro businesses with no intention of growing or using the financial data to make future decisions.
Keep in mind that depending on your type of business, you can use the accrual basis for internal purposes and the cash basis for taxes. Some entrepreneurs may find that the cash basis is more favorable for taxes.
Deciding whether to use the cash or accrual method can affect your business for years to come. Your financial data is a great asset to you as an entrepreneur, so having that information in the right format can make all the difference.
No matter what method you choose, the most important step to take for your future is to keep your bookkeeping up-to-date and accurate. Doesn’t matter which method you use if you don’t use it at all.
If you find that you are struggling with your bookkeeping, or just don’t want to do it anymore, then it’s time to hire a professional. Contact me below for a consultation to see if a virtual bookkeeper is right for you and your business.