Cash vs Accrual Accounting Method for S Corps

Accountants having a meeting to discuss whether to do cash basis accounting or accrual basis accounting

After you’ve made up your mind about what type of entity you want for your business, you’ll need to set up your accounting system right away. The first decision you’ll need to make is whether you’re going to use a cash or accrual accounting method. One method is not better than the other; they each have their own unique best uses and drawbacks. After a thoughtful review of your business model, you should make your choice depending on what works best for your S Corp.

Why Are There Two Different Accounting Methods?

The difference between the two accounting methods comes down to when sales and purchases are recorded as income and expenses in your books. Not every business collects income or has expenses in the same way. That’s why there are two available accounting methods to choose from.

Here are examples to help explain why different business models would want to use different accounting methods:

Scenario One: You own a retail bookstore, selling only new books. You buy books directly from the publisher to stock your inventory. That’s an immediate expense.

When you sell a book, your customer pays at the checkout. That’s immediate income.

Scenario Two: You own an antique store, selling items that members of the public bring into the store for you to sell. You agree to give the seller a commission on the sale of the item, if and when it sells. If the item sells, you contact the seller and they come in and collect their percentage.

Both your expenses and your income are in the future. You don’t pay for your inventory up front, and you don’t have an expense until the item sells and you have to pay out the seller’s commission.

In these two scenarios, the businesses would want to use different accounting methods, since they have different models for income and expenses.

What is Cash Basis Accounting?

Cash-based accounting is the most simple way of recording business financial transactions. With this method, income and expenses are only recorded when money is received or paid out. (Money, of course, can take the form of any financial instrument, i.e., check, cash, wire transfer, etc.) It’s popular with S Corps because of its simple and straightforward nature, and it makes it easy to keep track of cash flow. [1]

When to Use Cash Basis Accounting

Cash basis accounting is great for businesses that are simple in nature, such as an e-commerce or retail store. Other factors make this a smart choice, such as a lack of business investments, not having a seasonal business, a lack of stockpiled inventory, and no terms for customer sales. In other words, when the income and expenses consist of a simple purchase where money changes hands immediately, cash-based accounting makes good sense.

Drawbacks to Cash Basis Accounting

The drawbacks to cash-based accounting become evident over time. Due to the same simple features that make it so attractive for newer businesses, it can fall short in the future. It doesn’t have a method for tracking receivables or payables. 

woman doing cash basis accounting

Because of that, it makes it harder to assess the overall financial health and growth of a business. [2]

Is Cash Basis Accounting Right for Your S Corp?

Ask yourself the following questions to help determine if cash basis accounting may be right for your S Corp:

  • Are your financial transactions a simple matter of money in/money out in one transaction?
  • Do you have limited or no inventory?
  • Do you have a few employees?
  • Do you prioritize keeping your business finances simple?
  • Do you need to keep a close eye on cash flow?

If the answer is yes, then you should seriously consider cash-based accounting for your S Corp.

What is Accrual Basis Accounting?

In accrual-based accounting, you record income and expenses when they occur, even if no money changes hands at the time. It’s helpful to understand the word “accrued,” which means, “to be added as a matter of periodic gain.” In other words, you accrue income over a period of time. An example would be if you have a SaaS business. You sell your services, but the customer doesn’t pay you upfront for them. The sale takes place on one day, but you receive payment after the services are delivered.

When to Use Accrual Basis Accounting

Accrual basis accounting is suitable for businesses that offer terms on services rendered. For example, an engineering design firm where increments of the lump sum are due and payable upon certain phases being completed. By tracking income as it’s earned—rather than when it’s received—the company can better analyze its financial health. It also makes it possible to keep track of project expenses over time and match those numbers with revenue from any given project.

Drawbacks to Accrual Basis Accounting

woman doing accrual basis accounting

Despite its suitability for painting an accurate financial picture, accrual basis accounting does have its drawbacks. One being the record-keeping involved is much more complex. Whoever is doing the bookkeeping must track receivables, payables, and other non-cash items.

Is Accrual Basis Accounting Right for Your S Corp?

Ask yourself the following questions to help determine if cash basis accounting may be right for your S Corp:

  • Are your business’s financial transactions complex?
  • Do you work with long-term contracts or projects?
  • Do you need to track project expenses against revenue?
  • Are you a service-based S Corp?

If you answered yes to one or more of these questions, then your S Corp may benefit from accrual basis accounting.

Software for Cash & Accrual Basis Accounting

Your accounting should support your S Corp’s needs from startup through growth phases. Many young S Corps start simply, using cash-based accounting. All business accounting software can handle this accounting method, including Peachtree, Sage, Quickbooks, and Mint, among others. However, many business owners find that, as they grow, they wish to transition to a more complex model, where accrual basis accounting makes better sense. This is when it’s critical that you’ve chosen the right software for business accounting. In order to facilitate the possible transition to accrual basis accounting in the future, it’s imperative to choose software that supports the switch from cash basis accounting. One of these that comes highly recommended is Intuit’s Quickbooks Online. There may be others, and you will need to look deeper into their details to find out more. [3]

Cash vs. Accrual Accounting: How they Stack up

To summarize, cash-based accounting is ideal for young companies with little-to-no inventory, with simple transactions where money changes hands upon receipt of goods. Accrual basis accounting is better suited for larger businesses with more complex financials, and that have a need to track costs against project revenues. If you have lingering doubts as to which method might be best for your S Corp, get in touch with your CPA, who can help to guide your decision.

As you’re building your new S Corp, you need to be certain that you’re compensating your employees correctly. Too little or too great compensation could cause IRS red flags, and lead to trouble in recruiting and retaining top quality personnel. RC Reports offers a compensation analysis solution for small, medium, and large businesses. With our custom reports, you will save time, minimize risk, and improve revenue. Contact us to learn more.

References

1. Liddell, Christine (2023, November 21) Cash Basis Accounting | Method, Pros & Cons. Study.com

https://study.com/learn/lesson/cash-basis-accounting-method-disadvantages.html

“The main difference between cash and accrual accounting is timing and revenue recognition. In the cash accounting method, expenses are recognized when paid and revenue is recognized when cash changes hands.”

2. Morah, Chizoba (2023, November 28) Accrual Accounting vs. Cash Basis Accounting: What’s the Difference?. Investopedia.com

https://www.investopedia.com/ask/answers/09/accrual-accounting.asp

“That’s because it doesn’t record accounts payables that might exceed the cash on the books and the company’s current revenue stream.”

3. Quickbooks (2024, February 01) Choose between cash and accrual accounting methods in QuickBooks Online. Quickbooks.Intuit.com

https://quickbooks.intuit.com/learn-support/en-us/help-article/product-preferences/choose-cash-accrual-accounting-methods-reports/L64yocn6B_US_en_US#:~:text=Go to Business overview and,setting in the General section).

  1. Select Settings ⚙, then select Account and settings.
  2. Go to the Advanced tab.
  3. In the Accounting section, select the Edit ✎ icon.
  4. Select an Accounting method.
  5. Select Save, then Done.”

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