As of 2021, there were about 30.7 million small businesses in the United States (Source: United States Small Business Administration, 2021). In that same year, 5.4 million new business applications were filed, which was the highest of any year recorded, and a 53% increase from 2019 (Source: United States Census Bureau, 2021). With so many new small businesses out there, chances are there are many people out there trying to figure out whether they should track their income with cash vs accrual accounting.
It can be confusing. Do you track all of the money you receive at the time you receive it? What about if people are paying in installments? Do you track the full amount all at once, even if you haven’t received the funds yet? The process can get overwhelming, fast.
We’re going to demystify the two ways to track your small business income. You’ll learn the difference between the two, and the most accurate way to track and talk about your income.*
Tracking Small Business Income with Cash
In accounting, there are two different ways to track and report your income: on a cash basis or accrual (or sales) basis.
Tracking “cash” means tracking all the money that actually goes into and out of your account. For example, a small business might make a sale of $350 on February 1. The customer pays using a credit card, and the payment won’t be processed until February 7. Using the cash method, the small business would not track the $350 as part of their income until February 7, when the money is actually received.
There are many good reasons to track using the cash method. It’s straightforward and easy to follow, and it might help a small business in the newer stages of business to have an accurate picture of its cash flow and most importantly not overpay on income taxes.
Tracking Small Business Income with Sales
On the other hand, tracking income on an accrual basis means any invoices you send out are considered sales - even if you haven’t received the payment, you’re still reporting the income.
For instance, let’s go back to the small business that made the $350 sale on February 1. Even though the customer paid using a credit card, they will track the sale on February 1 as part of their income, even though they haven’t received the physical cashflow into their account yet.
This method might be best for a small business with a large amount of credit payments. It provides an accurate picture of a business’s financial situation, while also allowing it to manage its cash efficiently.
Cash vs. Accrual Accounting: Which One Should You Use?
From an accounting perspective, there is no right answer. Either works and is allowed. From a transparency perspective, the most important thing is to remain consistent.
For example, you shouldn’t say that you had a $50k month because you invoiced out $50k in one month, and then say you had a $50k month the next month because you actually collected the funds on those invoices. That would be unethical!
It’s recommended that small businesses report taxes on a cash basis since you have received the cash that you are reporting as income - and thus have the money available to actually pay your tax liabilities.
In my opinion, I talk to my clients about their profits. For instance, if a client says they had a $50k month, but they only kept $2k… then they actually had a $2k month! Maybe $48k was spent on advertising and investing back in their team, but it’s still taking away from their profit. So as their tax planner, if they were grossing $600k annually but only keeping $24k annually, I’d say they’re working way too hard, and it’s time to work together to fix that.
Whichever method you choose, be consistent and transparent in how you talk about your cash collections or your actual sales totals. When in doubt, talk to your tax professional to decide which income tracking method is right for your small business and tax filings.
Interested in seeing how our firm can help?
*Disclaimer: This article is not meant to be tax advice. This is not an all-inclusive list of business advice. Different rules may apply to each individual taxpayer’s specific situation. Please consult with your accountant.