There are two primary methods of accounting that your business can utilize to report income and expenses: accrual basis accounting and cash basis accounting. The main difference between the two accounting methods involves when transactions are recorded: with cash basis accounting, revenue and expenses are recorded either when it’s received or when it’s paid out (i.e. when cash has changed hands); with accrual basis accounting, transactions are recorded when revenue is earned and when expenses are consumed (i.e. cash has not yet been paid out).
In this post, we’ll provide a simple explanation of both the accrual accounting method and the cash accounting method, how they differ, the implications of each method on your business, and how to determine which method is best suited for you.
What is Accrual Accounting?
Accrual based accounting records revenues and expenditures as they’re earned and incurred, regardless of when cash is received or expenses are paid. If your business sells a product in June but doesn’t receive the revenue until July, for example, you record the transaction in June, regardless of when you receive the revenue.
The benefit of accrual accounting is that it provides a realistic view of your expenses and income. The downside is that it can be deceiving about your profitability, giving you less awareness of cash flow. Even if the business appears to have positive cash flow, it doesn’t actually reflect that status of your bank account. Still, accrual accounting is generally preferred because it better complies with IRS requirements and gives you that long-term visibility into your business.
What is Cash Accounting?
The cash basis of accounting recognizes revenue when cash is received, and expenses when cash is paid. Using the same example as above, if you sell a product in June but don’t receive the revenue until July, the cash accounting method doesn’t recognize the transaction until the cash has changed hands and your business has received the revenue in July.
The benefit of cash accounting is that your bank account is a real-time reflection of the resources you have at your disposal. The downside is that there is a delay in revenue and expense recognition. So if you get a sale in June, but don’t recognize that revenue until the transaction is processed one month later, you have less visibility into your business long-term.
Example of Cash vs. Accrual Accounting
To provide a clearer picture, here’s how invoices and payments would translate to your cash flow for Accrual Accounting versus Cash Accounting:
Let’s say your business performed the following transaction in one month:
- Sent out a $1500 invoice recently for a project you completed last month
- Paid $400 in expenses this month
- Received $1200 from a customer that you invoiced a couple of weeks ago
How this affects cash flow:
For Cash Accounting, the profit for this month would be $800 ($1200 – $400).
For Accrual Accounting, your profit would be $2300 ($1500 + $1200 – $400).
Essentially, the significant difference between accrual and cash accounting is the timing of when revenue and expenses are recorded on your income statement. The timing of the recording shows vast differences in cash flow.
Tax Implications of Cash and Accrual Accounting Methods
Businesses must figure their taxable income and file a yearly return. Choosing an accounting method will depend on the type of product or service you provide and the size of your business.
If your company generates less than five million dollars in revenue, the IRS permits the use of cash basis accounting. Therefore, small businesses are much more likely to use cash accounting. Anything over five million dollars in revenue, on the other hand, will require the accrual method. You will also have to use the accrual method if your business keeps an inventory of merchandise to sell to consumers.
Which Method Should Your Business Use?
Many small businesses opt to use cash basis accounting because it is the simplest method to use for recording transactions and cash flow. The cash method makes it easy to track how much cash your business has at any given time. There is also no need to track receivables or payables, and your business doesn’t have to pay income tax on any revenue until it’s deposited into your bank account. Cash accounting gives you an idea of the funds in your bank account and an immediate look at your business’ financial situation in terms of liquidity.
The accrual accounting method is the focus of professional accounting because it prevents manipulation of income by matching the expenses incurred in a period to the income earned in that period. Accrual accounting accurately reflects the revenues that have been earned to the expenses that have been incurred during a given period, providing a more long-term view of the business. When compared to the cash basis method, accrual accounting tracks cash much more effectively by allocating cash flows to the appropriate period. It also provides a better outlook into the financial results of the company, allowing for smarter business decisions and future growth.
Despite the increased accuracy of the accrual method, one drawback is that it doesn’t account for cash flow or funds in your bank account. Therefore, accrual accounting requires careful bookkeeping practices as you may see a large amount of revenue on the books but have considerably less money in the bank due to the revenue being earned but not realized.
The Accrual Method Is Better…In Most Cases
It is generally recommended to use the accrual accounting method because it will help your business better comply with IRS rules and more accurately reflect the actual financial situation of your business. While cash accounting may be easier to understand, accrual accounting is often more thorough and may even be a legal requirement for your business. If you choose to use the accrual accounting method, remember that it will affect your tax return as it can change which year you record certain incomes and expenses, and it can also dramatically change the appearance of your income statement.
Accurate and efficient reporting of income and expenses is critical to your business’ success. If you’re unsure of your legal requirements or which method best suits your business practice, speak to an accountant or your accounting service to ensure you’re on the right track. You can also reach out to a ScaleFactor expert for more information about the accounting tools your business could leverage for optimal financial health.
Make accounting practices a top priority from now on and ensure your bookkeeping is in order before it’s too late.
Editor’s Note: This post was originally posted on January 18, 2017 and has been completely updated for accuracy and comprehensiveness.