You may wonder which accounting method is better. The truth is that both methods give you only a partial view of how your business is doing. The accrual method more accurately matches your income and expenses, but if this method is not managed carefully, you could lose track of your actual cash flow. For example, you could be recording lots of income for jobs completed, but not receiving payments on a timely basis. In other words, your bank account could be empty, but you wouldn’t notice this lack of cash by just looking at your income statements. Yikes! What happens when that next check bounces? Don’t worry. We talk about how to manage cash flow when using accrual accounting when we talk about cash receipts and disbursals in Chapters 7 through 10.

The cash-basis method gives you a clearer picture of your cash flow, but it does not give you a good idea of the business’s long-term profitability because you don’t record income when it is actually earned and expenses when they are actually incurred. Many businesses earn income or incur expenses in one month and are not paid for the job or do not lay out the cash for expenses until many months later. Cash-basis accounting does not do a good job of matching income with the expenses incurred to earn that income.

Accountants recommend the accrual method for most small businesses, but if your business is truly a cash business, you may want to use the simpler cash-basis method. Even though this book focuses primarily on the accrual method, you will find plenty of information about setting up your accounting system if you have chosen to use the cash method. If you haven’t already done so, discuss this choice with your accountant to sort out what is best for your business.

The IRS requires you to use the accrual method if your business meets one or more of the following conditions:

Now we get into the next key decision you need to make if you haven’t already done so. What type of organizational structure should you choose: sole proprietor, partnership, or corporation?