Along with entity selection, another of the first decisions that any small business needs to make is whether to account for their business under one of two methods or basis, Cash or Accrual.

There is nothing terribly complex about this decision as it is a matter of establishing the timing of the business’ recognition of revenue and expenses.

Cash Method or Basis

A business that chooses the Cash Method recognizes revenue when it receives payment and expenses when it makes payment.  This is the simpler of the two methods and, as such, is the method chosen by most small businesses with revenues less that $5 million.  When revenues exceed $5 million use of the accrual method is required.

These characteristics of the cash method follow onto the business tax return.  Revenue is reported for tax purposes when it is received and expenses are deducted when they are paid.

The cash method will show a more accurate reporting of the business’s cash position, however it may show a more lumpy picture of the performance of the business.

Accrual Method or Basis

The accrual method recognizes revenue when the job or sale is completed and the customer is billed.  It recognizes expenses when the goods or services are received and the invoice is received.  Because of this timing change the business recognizes accounts receivable, customer invoices that have been issued but not yet paid.  Accounts Payable is also required to record purchased goods or services that have been received and invoiced but not yet been paid.

These characteristics of the accrual method follow onto the business tax return.  Revenue is reported for tax purposes when it is earned or invoiced and expenses are deducted when bills are received.

The accrual method will show a more accurate depiction of the business’s performance, however it may not show an accurate picture of the amount of cash reserves available.

The Choice

Although not cast in stone, I typically recommend the Cash Basis for businesses just starting out as well as for most established businesses that come to me.  It’s simplicity says it all.  In most cases at this level it’s all the business owner needs.