As a small business owner, you are responsible for the many complex aspects of your business, including accounting. But why bother learning accounting? What is its use? In this article, I will discuss the importance of accounting, the two methods of accounting, and various accounting software that make your life easier!
The Importance of Accounting
Accounting is often referred to as “the language of business.” It helps us describe the financial health of a business, make informed decisions about the future of a business, and stay compliant with local, state, and federal laws.
- Accounting provides various metrics that allow you to measure how well your business is performing. You can compare those metrics over the years (called horizontal analysis) to see trends in your revenue (money you earn), expenses (money you spend), and other important items. It is critical to your success as a small business owner to understand these metrics, how you arrive at those metrics, and what they mean for your business’s future. Implementing an accounting method and enforcing it precisely will give you an excellent sense of the direction of your business.
- Accounting provides excellent data that allows you to make important decisions about the future of your company. Perhaps your spending in a specific category has increased significantly and is eating away at your profits. How would you know about this without proper accounting procedures? You see, accounting is more than a boring compliance procedure. The data you generate from precise accounting methods helps you make informed decisions about the direction of your company. Regardless of how enjoyable you find the procedures themselves, I hope you see the value you can derive from them.
- Accounting also allows you to stay compliant with government rules and organizations, especially the Internal Revenue Service (IRS), which collects tax revenue for the federal government. The IRS can audit any tax return you submit within the last three years, and if they find any issues, they can extend that audit up to the past six years. A list of some commonly required items during IRS audits can be found at Audits Records Request | Internal Revenue Service. Maintaining accurate accounting records and keeping important documents relating to those records (loan agreements, legal records, employee documents, etc.) will ensure you stay tax-compliant, pass IRS audits, and minimize the amount of taxes you need to pay.
Cash and Accrual Basis Accounting
Cash basis accounting records business transactions when cash is exchanged. For instance, if you sell a product to a customer, you record the increase in the cash and revenue accounts when the customer gives you cash. Whether or not promises or obligations exist to pay or receive cash is irrelevant. In terms of timing, the only thing that matters is cash leaving or entering the bank. Even if you incur utility bills in June, cash-basis accounting only recognizes a transaction when you pay the utility bill in July with cash. This is the more intuitive, familiar method, because it is generally how we manage our personal finances.
Accrual basis accounting records business transactions when revenues are earned and expenses are incurred. If I own a printing business, I will record revenues when I print a customer’s order, regardless of when cash enters the bank. It could be instantly (in which case cash and accrual basis accounting would produce the same accounting entry), or I could only receive the cash in two months. Regardless, I must record the revenue in the same period as I earned it. The same goes for expenses. Expenses are recorded in the period that they are incurred, not the period they are paid in. Since this can be tricky to understand, accountants created the matching principle to help us know when expenses are being incurred. The matching principle states that expenses should be recorded in the same period as the revenues they helped generate. Expenses are “matched” to their respective revenues. If I have employees in my restaurant who worked during June, I should record an expense for wages in June under accrual accounting, even though I only paid them in July. The expense belongs in the period that it was incurred, not paid.
Perhaps, from the prior descriptions, you already have a basic idea of the differences that result between using cash and accrual accounting. First, cash accounting is far easier! You simply record transactions when cash enters or leaves the bank, and you are done! Accrual accounting can be far more difficult, as it involves using a set of principles, called generally accepted accounting principles (GAAP), to determine when revenues and expenses should be recognized, as well as to what accounts and in what amount. Second, because it is more involved, accrual accounting can provide a more complete picture of the financial health of a business. If you incurred $5,000,000 in expenses but never paid cash payments towards your bills, cash basis accounting would make your business’s financial health look far better than it really is! Since accrual basis accounting tracks obligations, it tells a more complete story about the health of your business. “But,” you might argue, “since accrual accounting tracks transactions regardless of whether cash has been exchanged, it may lead business owners into depleting all of their cash without realizing it.” This is a common misconception about accrual accounting. In accrual accounting, GAAP provides guidelines for creating a statement of cash flows, which shows how the company’s cash balance is moving. This way, business owners understand exactly how much cash they have, where it is being used, and where it is being generated.
So, which method should small business owners use? As with most things in accounting and tax, it depends. The IRS allows you to choose whichever method you prefer for tax purposes, with one main exception, called the gross receipts test. Add up your business’s income for the past three years and then divide by 3. If the number is more than $30 million as of 2025, you have to use accrual accounting. I assume this does not apply to anyone reading this article as it is intended for small business owners, so I will assume from here on out that you are eligible to choose either. If this is the case, the choice really comes down to the scale and complexity of your business, and whether or not you stock inventory for sale.
Note: You are allowed to keep cash basis records for internal purposes but report income and expenses on an accrual basis for tax purposes and vice-versa. However, this involves keeping two separate accounting records.
Scale & Complexity: If you are operating a small, local business without the ability to pay professionals to adjust and maintain your accounting records, then cash basis accounting may be the more attractive option to you. On the other hand, suppose your business is growing quickly and you have the funds to hire professionals. You may consider using accrual accounting to give more detail to your accounting records for decision-making purposes. Banks and investors will likely also expect financial statements compiled using accrual accounting when issuing large sums of money, because they want a more complete picture of your business’s financial health.
With small businesses, it is likely that most of your transactions are in cash regardless, so cash basis accounting fulfills your needs. However, as businesses grow, they generally accept and make an increasing number of payments on credit, meaning they conduct more business based on promises than on hard cash. This is why accrual accounting becomes highly common as businesses transition to medium and large enterprises.
Inventory: The IRS requires businesses that need to account for inventory to use the accrual method for purchases and sales of inventory UNLESS they:
- Fall below the gross receipts threshold (your average revenue for the past three years is less than $30 million).
- Are not a tax shelter as defined by the IRS. If you do not know what a tax shelter is, you are probably not a tax shelter.
As a practical matter, if you consider yourself a small business owner, it is exceedingly likely that you are free to pick cash accounting, regardless of whether you sell inventory. All small business taxpayers as defined by the IRS can use cash basis accounting for inventory (and everything else for that matter). I don’t want to get too deep into the tax implications of cash and accrual accounting, but just know that accrual accounting gives you more wiggle room for tax planning and helps you track inventory more accurately. If you are willing to employ accounting software, learn accrual accounting, and consult a professional when things get difficult, using accrual accounting may be worth it in the long run due to tax savings and improved financial strategy. The most important thing is that your chosen method suits your business’s needs, provides an accurate account of your business’s financial health, and is sustainable for you to implement.
–> Remember, you should choose wisely, but you can change your business’s method of accounting using IRS Form 3115 subject to IRS approval.
Accounting Software
There are many different companies offering accounting software, but similar to your choice of accounting method, your choice of software will come down to your individual needs. The following section details a few of the most popular software for small business owners.
Intuit QuickBooks Online (Comprehensive Emphasis)
QuickBooks Online is a favorite of many small business owners looking for a software that combines powerful reporting and tracking features with ease of use. Some commonly listed highlights of QuickBooks online are its accuracy, integration, customization, and relative ease of use. However, QuickBooks Online is relatively expensive compared to similar software and features some repetitive functions. It is best for small business owners who need integration with other systems like time clocks and payroll, and who do not mind paying slightly more for the software’s comprehensive offering.
Intuit offers several other versions of QuickBooks like QuickBooks Enterprise, QuickBooks Desktop Pro, QuickBooks Online Advanced, and QuickBooks Solopreneur. These may better suit your needs than QuickBooks Online, so they are worth checking out!
Xero (Multiple User Emphasis)
Xero is another popular accounting software that is widely used by small business owners who need multiple people to regularly access the software. Xero is relatively inexpensive and is known for its user-friendliness and easy implementation, but lacks the comprehensive built-in features offered by QuickBooks. For example, users wishing to add payroll functions must pay an additional $39/mo to add Gusto as a payroll system. It is best for businesses with multiple users who generally do not require the additional built-in features offered by similar software.
FreshBooks (Service-Based Business Emphasis)
FreshBooks is an intuitive accounting software that aims to offer a great user experience while maintaining all the features necessary for more complex businesses. Freshbooks boasts built-In payroll and inventory tracking features, an easy-to-use interface, and excellent integration. However, FreshBooks has notably weaker inventory and document management features as compared to similar software. It is best for service businesses looking for an excellent user experience.
Sage 50 (Inventory Management Emphasis)
Sage 50 is a robust accounting software that connects various aspects of the business to reduce overlapping tasks and reduce administrative burdens. It is known for its Microsoft 365 Business Integration, advanced inventory management, and in-depth reporting and analysis capabilities. However, it is only available on Windows and lacks the same “easy-to-use” emphasis as other similar software. Sage 50 is best for small business owners who need a powerful inventory management software and don’t mind a steeper learning curve.
Wave (Invoice and Small Business Emphasis)
Wave is a user-friendly accounting software that aims to make bookkeeping, taxes, and invoices seamless. Its highlights are its exceptionally easy-to-use dashboard, a heavy emphasis on small businesses, robust invoice management, and mobile app integration. However, the software does not offer time tracking or project management features. Wave is best for small business owners looking for an excellent invoice system combined with a simplistic user experience.
The Accounting Geek 
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