Ah, accounting methods—a seemingly dull topic that can make or break your business finances. Understanding the most common methods and knowing which one suits your business is crucial for clear financial reporting, tax compliance, and smart decision-making.

Let’s break down the two most common accounting methods: cash basis and accrual basis.

1. Cash Basis Accounting

How It Works:

With cash basis accounting, you only record income when you receive cash (or other payment) and expenses when you pay cash. Simple, right? If the money hasn’t hit your bank account yet, it doesn’t exist in your books.

Pros:

• Simplicity: Easy to understand and implement.
• Clear Cash Flow Picture: Since transactions are recorded only when money changes hands, it’s easy to track actual cash in and out.
• Tax Timing Flexibility: You can control the timing of income and expenses to some extent (e.g., delaying an invoice until after the new year).

Cons:

• Limited Insight: Doesn’t give a complete picture of your financial health because it ignores outstanding invoices and bills.
• Not GAAP-Compliant: Generally accepted accounting principles (GAAP) require accrual accounting, so if you plan to seek funding or grow significantly, cash basis may not cut it.

Best For:

• Small businesses, freelancers, or solopreneurs with simple operations and few accounts receivable/payable.

2. Accrual Basis Accounting

How It Works:

Accrual accounting records revenue when it’s earned (even if you haven’t been paid yet) and expenses when they’re incurred (even if you haven’t paid them yet). This method reflects your business activity, not just cash flow.

Pros:

• Comprehensive Financial Picture: It shows revenue and expenses when they happen, giving you a more accurate view of profitability.
• Better for Long-Term Planning: Since it tracks all receivables and payables, you can make smarter decisions about growth, inventory, and financing.
• GAAP-Compliant: Essential if you plan to attract investors or need to prepare audited financial statements.

Cons:

• Complexity: It’s harder to manage because you’re tracking revenue and expenses before cash changes hands.
• Cash Flow Challenges: You might show a profit on paper but still run into cash flow issues if receivables aren’t collected promptly.

Best For:

• Businesses with inventory, multiple income streams, or plans to scale up.
• Companies that need accurate financials for investors, lenders, or regulatory compliance.

How to Choose the Right Method

Here’s a simple way to decide:

1. Consider Complexity – If your business is small and cash flow is easy to track, cash basis is likely sufficient.
2. Look at Your Industry – Businesses with inventory or those offering credit to customers often need to use an accrual basis.
3. Think About Growth – If you’re aiming for rapid growth, external funding, or partnerships, accrual accounting provides a clearer picture of your business’s financial performance.
4. Tax Requirements – Some businesses (like C corporations and those with over $25 million in revenue) are required to use accrual accounting for tax purposes.

Which Method Is Easiest for a Small Business?

Cash basis is the easiest to set up and manage for most small businesses because it aligns directly with cash flow. It’s as simple as tracking deposits and withdrawals. If your primary concern is keeping tabs on your bank balance and ensuring you have enough to cover expenses, cash basis is the way to go.

However, if your small business has even modest complexity—say, you invoice clients and sometimes wait 30-60 days for payment—you might outgrow cash basis quickly. In that case, consider hybrid accounting, where you record income using accrual and expenses using cash, giving you a bit of both worlds.

Final Advice:

• Start Simple: Use cash basis if you’re just getting off the ground and want to keep things manageable.
• Know When to Switch: As soon as you start issuing invoices or carrying inventory, it’s worth upgrading to accrual to get a better handle on your business’s true financial state.
• Use Accounting Software: Tools like QuickBooks Online or Xero can make either method easier to manage, and many allow you to switch between methods as your business evolves.

Need help setting up your accounting system or choosing the right software? I’m here for that too!

Karrie Jackson

Co-founder of Evermore Accounting & Coaching