How to choose between Cash and Accrual Accounting

I just started my first business. I’m debating on whether to go with cash-basis accounting or accrual accounting. From what I’ve read it seems that cash-basis is the easier method, but accrual is more widely used and respected. Based on current IRS law, I can go with either method. My initial thought is to start off with cash accounting and switch to accrual later on when the company takes off. But I'm not sure if that's the best way to go. I plan on discussing this with an accountant, but I wanted to run it by here first.

I have two questions:

1. Which would be the better choice for my particular situation?
2. Has anyone changed their initial accounting method after a few years in service? If so, how complicated was it?

Background on my particular situation:

• Our company consists of 2 founders and no employees.
• We may hire an independent contractor in the future, but we don’t have any plans to do it in the near future.
• We're registered as an LLC and being taxed as a partnership.
• I plan on doing the bookkeeping myself, but I have no previous experience in bookkeeping.
• We’re developing a software product. Our revenue will come from selling licenses of the product.
• We don’t expect to have any income in the first year.
• We don’t expect to have any major expenses in the first year either.
• We work from home.
• We won’t have to deal with inventory.
• We’re located in Maryland.

Definitely go with cash-basis. Primary reason: You have to pay taxes with cash. If you use cash-basis accounting, taxes will be proportional to the amount of cash that you accumulate. Because you accumulated real cash, you can by definition afford the taxes. (Set aside ~30% for taxes every month.)

Secondary reason: If you chose accrual and if you grow, you typically have less cash profit than accrual profit. For example, you'll be behind on your collections which means you don't have the cash in hand -- and customers might even stiff you -- but on an accural basis you "have the revenue" and have to pay taxes.

Accounting has two purposes:

1. To pay taxes properly.
2. To tell you whatever you need to know about the financial health and operations of your business.

Remember that you're not restricted to just one type of accounting! You just pick one for the IRS (1).

But for (2), you do whatever is useful. For example, if you're trying to plan out whether you can afford to blow $10,000 on a new marketing experiement, you need to use cash-basis to ensure you'll have the cash to do it.

But if you're trying to determine "In general am I earning more revenue than expenses each month," an accural-basis is more accurate. That is, regardless of whether you chose to pay the telephone bill on time, and whether your customers are paying on time, what's actually being incurred? Because those two things are separate problems.

This has been an old question but my viewpoint quite differs from other answers, so I'm just sharing these thoughts...

First of all, I'm highly surprised the IRS allows you to pick the accounting reporting method. To me, the IRS should be concerned with how much money companies are earning, not how much cash they have (they might tax assets, but this should not be their concern for income tax). So anyway, my advice is to go with accrual-based accounting.

My arguments are as follows:

• To me, accounting principally serves a business owner to be informed about the financial situation of the company. The IRS is a secondary user. YOU want to know how much you earned. By using accrual-based accounting, you'll have a better idea if your company is doing fine. You could be undertaking many cash-generating but ultimately costly activities (say you charge customers upfront but pay providers monthly). You want to know about this.
• At the end of the day, you'll normally not pay less tax. You will only pay tax later using cash-based accounting if you pay your bills earlier than your clients pay them (generally speaking). And yes, there's time value of money, but for a startup I do not think we're talking about a whole lot of money.
• On the long term, I think we all agree that accrual-based accounting is best. When starting out in accounting, it's better to start out the 'right' way. If your company grows and you decide accrual-based accounting is better, you'll have to get used to that and again spend time learning the ropes. Keeping two sets of books as suggested in the accepted answer is inconvenient and a time-waster as well, I'd say.
• The argument that you should be happy to pay less tax when clients do not pay on time and you can pay less taxes does not fly. If my clients pay so late that by the time of paying my taxes I don't even have the money, I should be worrying about how to change this situation, not celebrating my tax choices. Also, whatever you 'save' in year 1 comes back as extra in year 2.

Just some thoughts from the 'opposing' side...

In general you should use "cash basis" accounting if you are a service type of company which you are. You would use an "accrual based" accounting if you are say a construction company or a company that maintains an inventory that is used on different projects.

Definitely agree with Jason. You will have to switch eventually (I think when you reach $5M in revenue) but stay as cash basis as long as you can. Switching is not a big deal. There are significant benefits of cash basis in addition to what Jason indicated:

• At the end of the tax year, if you're making money you can ask customers to delay paying you to delay the tax burden
• At the end of the year if you're making too much money you can prepay expenses or buy new equipment to lower your current tax burden

Overall you have a lot more flexibility in managing your tax burden when you're on a cash basis.

In the UK you must use accrual accounting for some taxes, I don't know about the US.

For your in-house “management” accounting for cash flow, I would use.

• Accrual for money you must give other people
• Cash for money other people may give you

That way you are less likely to get surprises.

Per IRS, taxes are reported on cash basis until you have inventory or substantial assets. It is a major hassle to change your tax reporting basis without very good reason.

However, you can keep your books on accrual basis and still do your taxes on the cash basis - a very common practice, and not all that hard to calculate - any living accountant does this many times a year.

It is easier on some respects to keep the books on a cash basis from a bookkeeping point of view, but there are some management reasons to use the accrual basis. The main difference is that accrual basis accounting keeps track of the invoices you have sent, and it keeps track of the bills you have to pay.

IF you issue invoices, accrual basis accounting is the way to go, so you can keep track of who owes you what (called 'accounts receivable'). What cash you have in hand you know from your current bank balance, but accrual accounting will tell you cash you might expect to be coming in, too. Accrual basis accounting also keeps track of what bills you have coming up and who you owe (called 'accounts payable'). Comparing your accounts receivable with your accounts payable helps you better manage cash flow than cash basis accounting does.

IF you issue invoices or accept payments over time, you can compare cash basis accounting to driving a car by looking in the rear view mirror, while accrual basis lets you look through the windshield.