Two Types of Business Accounting Methods

by Cam Merritt

Businesses in the Unites States do their accounting under one of two methods: cash and accrual. The difference lies largely in when a business recognizes the revenue it earns and expenses it incurs. Most small businesses can choose either method. However, once a business meets certain criteria, it no longer has a choice -- it must use the accrual method.

Cash Accounting

Cash accounting is the simpler of the two methods. In fact, most people practice cash accounting in their daily lives, because it's how they balance their checkbook. In cash accounting, all that really matters is the actual flow of money. Revenue only goes on the books when money comes into the company; expenses are recorded only when money goes out of the company. Say you owned a carpet-cleaning business, and you did a job and billed your customer for the work. You earned the money when you cleaned the customer's carpets, but you won't record any revenue until the customer actually pays up. Similarly, any expenses you incurred to do the job go on the books as soon as you pay them.

Accrual Accounting

In accrual accounting, what matters is not when money changes hands, but rather when money is earned. In the previous example, you would book the revenue for the carpet-cleaning job as soon as you earned the money -- when you actually cleaned the carpets. The fact that the customer hasn't paid yet doesn't matter for revenue purposes. Also in accrual accounting, expenses are matched to the revenue they produce. Say the carpet-cleaning job required a special disposable attachment for your equipment. You'd record that expense at the same time you record the revenue for the job -- regardless of when you actually bought the attachment.

When Accrual Is Required

The Internal Revenue Service requires certain businesses to use accrual accounting. Any business with sales of more than $5 million a year generally must use the accrual method. Businesses that maintain an inventory of items they sell to the public and that have gross receipts of at least $1 million a year also must use accrual. Publicly held corporations are required to use accrual, too. Most small businesses are eligible to use cash accounting, although they're certainly permitted to use accrual if it works for them.

Advantages of Each

Cash accounting provides a more accurate picture of your company's cash flow, and thus its ability to pay its own bills. Under accrual accounting, a company can have plenty of reported revenue but still encounter a cash squeeze if customers' bills have yet to be paid. On the other hand, accrual accounting provides a more accurate picture of a company's business activity -- when it is earning money.

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