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Understanding cash vs. accrual accounting: A guide for small business owners

Accounting is an important part of running a small business. Whether you handle your own finances or work with an accountant, it's important to understand different strategies for bookkeeping.

Cash basis and accrual basis are two common methods of accounting for business. They both have potential advantages and disadvantages, and each can be useful for different types of businesses.

In this guide, learn more about the key differences between cash and accrual accounting.

What is cash basis accounting?

Cash basis accounting is the process of reporting only income that has been received and expenses that have been paid. Meaning, a business won't report open invoices, bills, or accounts payable that haven't been paid off yet.

So if a small business purchased inventory on credit in December and didn't pay it off until January, it would only be listed as an expense in January.

Advantages of cash basis accounting

Some of the potential advantages of cash basis accounting include:

  • Simplicity and ease of use. It can be easy to calculate revenue that has already been received and expenses that have already been paid.
  • Only pay taxes on income you've received. This can be helpful for small businesses that are still growing their revenue streams.

Limitations of cash basis accounting

There are certain limitations of cash basis accounting, such as:

  • Limited insight into long-term financial health. Cash basis accounting only considers current profits and expenses, not any unpaid invoices or debts. This can make it difficult to forecast the impact of future bills and payments.
  • Inaccurate representation during rapid growth. A business might look profitable to managers and investors, but it could have a range of upcoming expenses that will offset those profits.

What is accrual basis accounting?

Accrual basis accounting is the process of reporting income and expenses even before they are fully paid. So if a customer is billed but they haven't paid yet, it's still reported as revenue. And if inventory is purchased but not paid off yet, it's still reported as an expense.

Advantages of accrual basis accounting

Some of the potential advantages of accrual basis accounting include:

  • Accurate long-term financial picture. You can better understand and prepare for future financial performance and fluctuations.
  • Better tracking of unpaid invoices and receivables. Stay on top of unresolved bills and payments by reporting them.

Limitations of accrual basis accounting

It's also important to understand the possible limitations of accrual basis accounting, such as:

  • Complexity. It may take more time and resources to track unpaid revenue and expenses instead of just current cash flow.
  • Potential for higher taxes in the short term. You may have to pay taxes on income you haven't received yet. This can be difficult for small and growing businesses.

When to use cash vs. accrual accounting

Take these factors into account to decide when to use cash vs. accrual accounting:

  • Industry and regulatory requirements. According to Generally Accepted Accounting Principles (GAAP) regulations, businesses that are publicly traded or earn over $25 million in sales must use the accrual basis method of accounting.1
  • Business size and growth stage. Cash basis accounting is a popular solution for small businesses and sole proprietors because of its simplicity. However, fast-growing businesses may choose to use accrual basis accounting to avoid making the mandatory transition later.
  • Tax implications. Remember that with cash basis accounting, you generally only pay taxes on income you've already received. With accrual basis accounting, you normally pay taxes on any sales transactions that have been initiated, even if money hasn't exchanged hands yet.

Transitioning between accounting methods

Transitioning between cash vs. accrual accounting can be complicated. If you're used to only tracking current cash flow, you may need additional resources to start reporting unpaid invoices and expenses.

It's important to adhere to any IRS compliance standards regulations when reporting income on your taxes.

Businesses can also use PayPal accounting solutions to manage their billing, invoicing, and taxes from one place. Learn more about PayPal's integrated accounting software.

Which accounting is most suitable for your small business?

Cash and accrual basis accounting each offer unique benefits for different types of businesses. It's important to understand each method so you can choose the right approach for your financial needs. Remember to consult an accounting professional or financial advisor for guidance as you grow your business.

You can also use your PayPal Business account to streamline transactions and find new ways to improve your financial health. Learn more about managing your finances and accounting with PayPal’s Business Resource Center.

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