Which accounting method should I use for my small business?

Q: Dear Ruchi, this is my first official year as a business owner. I am getting worried about tax season even though it is many months away. When it comes to anything accounting related, I instantly feel stressed and confused. I have heard about the different methods of accounting but it’s “all Greek'' to me and I am struggling to decide which one will be the best for my service-based business. Help!

A: Before you worry about the different types of accounting methods, allow me to ease your mind. Luckily there are only two main ways businesses can account for income and expenses, so this narrows down your choices already!  Ultimately this choice will be fairly simple, depending on the type of business you run (services vs. products/retail) and your revenue range. Regardless of whether you plan to handle your own finances or hire a professional, I can help you understand both methods so that you have a better picture of how they work. 

Let’s break them down below:

1) Cash Basis Accounting

The cash basis method is generally the method of choice for a service-based business (unless you make over $25 million a year based on current tax rules), and is the simplest way to report your numbers. When you use this method, you recognize income when it is received (rather than when it was earned/invoiced) and expenses when payments are made, so you can account for cash flows as they happen. 

For example, if you invoice a client on June 29 and are paid on July 15, you would recognize that income in July, not June. The cash basis method is an effective way to track cash flow, and in this method you aren’t taxed on the income until you receive it.

2) Accrual Basis Accounting

The accrual basis method is almost always the method of choice if your business holds inventory.  In this method, income is recorded when it is earned and expenses are recorded as they are incurred, rather than when cash is received or paid. This method will require extra attention from a reporting perspective, and is more administratively cumbersome due to the proper tracking of inventory.

For example, a business owner records $1,500 worth of sales when the jewelry she sells is shipped out to customers and deducts $500 for the cost of goods sold in the same month. However, she doesn’t receive payment from those sales until the following month. Using this method, she understands how much is expected to be made during that month even though the cash flow timing isn’t representative of her earnings. Ultimately, the accrual basis method gives a better idea of trends over time. 

Which is better for your business?

Since you are a small, service-based business, the cash basis method is generally the way to go!  This will provide the most ease in reporting too. Once you make a decision of what will work best for you, speak with a qualified accountant to verify the tax rules and how those impact your decision.

Here’s to your prosperity!

Ruchi