For a company just starting off or one that’s been around for a few years, you have a fundamental question to decide about your accounting practice.

Do I use cash accounting or do I use accrual accounting?

There are many factors to consider. All things being equal, I suggest you pick the way that would most actually reflect how your business is really operating. Too often, I’ve seen companies use the cash method of reporting and, perhaps, save themselves money on income taxes, but it comes at a very high price. The price is not understanding how their business is performing. The price is not really knowing what their margins are and are they making money on particular products or services. You might think this is second nature, but, believe me, I’ve seen it many, many times where because a company is reporting on a cash basis, they are no longer matching up revenues and expense. The income statement loses its credibility and meaning.

Certainly, though, tax should be considered. By using a cash method, you might be able to save significantly on income taxes. If so, you might want to take advantage of that. However, you should also consider though if there are ways to keep your books in such a way that you can still have a good handle on how your business is really doing while still making the appropriate tax adjustments for cash to get the tax savings that you are looking for.

Another can be your particular type of business. If you have a manufacturing operation or are dealing with inventory, then once you’re past a certain size, the IRS is going to dictate that you use accrual accounting. Check with your tax advisor to be sure about that.

That leads to another question, which is the size of your operation. As a smaller size company, you might be able to get by with cash accounting, but once you get to a certain size you may find that you have to move to accrual accounting.

You also need to consider your target audience. Your investors, banks or, perhaps, a future buyer of your company might have a great preference towards an accrual method of accounting.

When you’re starting up a business or in the early stages, you have a lot of decision to make, but give this accounting question some thought. It can be a rather basic, but one of the more important and pervasive questions that you have to decide upon. Make the wrong choice and you could be leading yourself down the path of poor decision made on misinformation down the road.

Jon Paul, MBA, CPA, CMC, CM&AA

President, Value Added Finance Resources
Bringing new insights on results and maximizing company value