The difference between cash vs accrual accounting is when transactions are entered into the books.
With cash accounting, transactions are entered when they actually occur. With the accrual method, transactions are entered when they are incurred.
For example, let’s say you do a job where the client will pay at a later date. With the cash method, you won’t record that income until the client actually pays. But with the accrual method, you will record it as soon as you complete the job.
What is Cash Basis Accounting?
Simply put, cash basis accounting works in real time when it comes to how you pay out and take in the cash for your business. You record income when you actually receive the cash payment and you record expenses when you actually pay for the expenses.
For example, let’s say you run a cleaning business. You do a job for a client in January, however, you don’t actually receive the payment for the job until February. If you’re running your business using the cash basis accounting method, you wouldn’t record that income until you receive the cash in February.
The same goes for expenses. Let’s say you purchased some office equipment in January. You took advantage of 60-day interest-free financing and didn’t pay for the equipment until March.
With the cash accounting method you wouldn’t record the purchase of that equipment in your books until you actually paid for it in March, even though you brought the equipment into your office in January.
Since you are recording income and expenses in real time, the cash basis accounting method has no use for Accounts Payable and Accounts Receivable (AP/AR) records. While this can help simplify the money management of your business, having no AP/AR records can cause problems. We’ll talk more about those potential problems later.
Related Article: Accounts Payable vs Accounts Receivable: What’s The Difference?
What Are The Pros And Cons Of Cash Basis Accounting?
From a business management standpoint, cash basis accounting can seem easier. You run it like your personal checkbook, recording debits and credits as they actually happen.
Also, cash basis accounting can be more beneficial from a tax standpoint if you can delay your income reporting until the next year.
For instance, let’s say you close out your tax year in December. You’ve made a large sale in December, but the client isn’t going to pay you until January. You’ll have already incurred the expenses related to that sale and put them in your books.
But the income from that sale won’t show up until January, thereby lowering your taxable income for the current year.
However, using cash basis accounting does have its downsides. Mainly, because cash basis accounting has no record of accounts payable and accounts receivable, this type of accounting makes it tough to have an accurate picture of your company’s current financial situation.
Recording income and expenses apart from when they actually occurred can result in missed items in your accounting records. It can make it harder to track unpaid income and debts as well.
For these reasons, the accrual accounting method is often used by professional accountants.
Related Article: What’s The Difference Between A Bookkeeper And An Accountant?
What is Accrual Accounting?
With the accrual accounting method, you record transactions as they occur, regardless of whether or not you received or made payment. So, if you sold a product or service in December, the transaction would be recorded in December even if you didn’t get payment until January.
Similarly, if you bought office equipment in May you would record the purchase as occurring in May even if you didn’t pay for it until July.
Your AP/AR records would reflect the income/expenses due for those transactions, thereby giving a full and accurate picture of your company’s income and expenses for the year. So while cash basis accounting uses real-time records of when the money went in or out, accrual basis accounting uses real-time records of when the sale or purchase actually occurred.
What Are The Pros And Cons Of Accrual Basis Accounting?
For that reason, the accrual basis accounting method is a more accurate method for keeping track of your business income and expenses. This method also minimizes any chance of forgotten transactions in your business.
Know that the accrual basis accounting method is more labor intensive. However, it also allows for a more complete and neat picture of your company’s financial health.
But which method should you use for your business?
Which Method Is Best For Your Business?
So, which method of accounting should you use for your business? The answer to that question depends on a few things.
First, you should know that businesses with over 25 million dollars in gross annual sales during the year can’t use cash basis accounting. If your business sales are at or near that number, you probably want to stick with the accrual basis accounting method.
Also, switching accounting methods for your business requires filling out a form with the IRS. In addition, the IRS won’t let you switch methods during the year. You’ll have to wait until the end of your business year before you switch.
Third, the type of accounting you use does depend on your accounting/bookkeeping staff. You may prefer to use one over the other. However, professional accountants typically choose the option that matches your tax filing status. In other words, they will work with cash accounting if your tax status allows it. Then they’ll move to accrual when your business changes to C-Corp status or hits the required revenue thresholds.
Lastly, remember that accrual basis accounting does typically present a more accurate financial picture for your business. It may be that your business is one in which there’s not typically much of a time lag between billing and receiving payment for work. Or between purchasing and paying for expenses. But if there is that lag then accrual basis accounting provides for more accuracy in knowing the big picture financials of your business.
Running Cash Accounting With Accrual Reporting
A side note: Quickbooks Online does allow for accountants to run financial statements in either format. For that reason, many accounting service companies will operate in an accrual method. Then they will give companies the Profit & Loss and Balance sheet in the cash basis. And they can provide a separate A/R and A/P report so you can have those accrual numbers is you are operating in cash accounting.
In addition, some business owners might find the accrual method more difficult to understand and interpret.
Yes, the accrual method is more accurate. However, smaller businesses like sole proprietorships with no lag in payment for services or goods may be able to function better using the cash basis accounting method because they are so cash driven.
So if you find this to be true and find the cash accounting method easier to understand and your business falls within the tax filing status to work under cash accounting, feel free to do so and ask for the appropriate accrual reports when needed.
The type of accounting method used in your business can have a large impact on the success or failure of your business. This is why it’s important to choose that method carefully.
Would you rather focus on sales and service to help grow your business? Consider hiring a professional accountant can take the time-intensive job of accounting and taxes off your hands completely. Learn more about how Cloud Friday’s accounting services can help you here.