Choosing the right accounting method is one of the most important financial decisions a small business owner can make. It affects how you record income and expenses, how you plan for taxes, and how accurately you see your company’s financial health.
The two most common accounting methods are cash accounting and accrual accounting. In this blog, we’ll walk you through what each method means, the pros and cons of both, and how to decide which one is the best fit for your business.
What is Cash Accounting?
Cash accounting is a straightforward method where income is recorded when cash is received, and expenses are recorded when they are actually paid.
Example:
You send a customer an invoice in January, and they pay in February. Under cash accounting, you record that income in February, when the money arrives.
Advantages of Cash Accounting:
- Simple to use and easy to understand
- Reflects actual cash flow
- Useful for small businesses, sole proprietors, and freelancers
Disadvantages:
- Can give an incomplete view of your financial situation
- Doesn’t show money you’re owed or expenses you’ll need to pay later
- Not allowed for businesses with over $25 million in annual revenue (as per IRS rules)
What is Accrual Accounting?
Accrual accounting takes a broader view. You record income when it is earned, and expenses when they are incurred—regardless of when the cash is received or paid.
Example:
If you send an invoice in January, you record the income in January—even if the payment doesn’t come until February.
Advantages of Accrual Accounting:
- Provides a more accurate financial picture
- Matches income and expenses to the time periods they relate to
- Preferred by lenders and investors
- Helps with long-term planning and financial forecasting
Disadvantages:
- More complex to manage
- May require professional help or accounting software
- Doesn’t reflect actual cash on hand, which could be an issue for cash-strapped businesses
Which Accounting Method is Right for Your Business?
Here’s a quick overview to help you decide:
- Business Type Recommended Method
- Freelancers and Sole Proprietors – Cash Accounting
- Service Businesses with Invoicing – Accrual Accounting
- Product-Based Businesses – Depends on size/needs
- Businesses Seeking Loans or Investors – Accrual Accounting
- High-Growth Startups – Accrual Accounting
If you’re running a small or new business with simple finances and you mainly get paid at the time of sale, cash accounting may be easier and more manageable. But if your business is growing, offers services on credit, or you want a clearer picture of your overall financial health, accrual accounting may be the better choice.
IRS Requirements to Keep in Mind
If your business earns more than $25 million in annual gross receipts, the IRS requires you to use the accrual method.
Once you choose a method, you need to stick with it consistently, unless you get IRS approval to change it.
Final Thoughts
Cash accounting is simple and works well for many small businesses, but accrual accounting provides better insight for long-term planning and financial management. Your choice should depend on your business model, cash flow needs, and growth goals.
Still unsure which method to use? A qualified accountant can help you evaluate your options and choose what makes the most sense for your situation.
Need help setting up the right accounting system?
Reach out to our team today and let’s get your finances in order—with clarity, confidence, and compliance.
