Picture this: You just opened your first business selling handmade items, and you see this little check box asking if you are reporting your Income and Expenses as Cash Basis or Accrual Basis. Your first thought is, “What is that and what is the difference?” and your second thought is probably “Why would I know that?” “Which is best for me?” is then likely your third question. To avoid the stress that the last three questions create, the answer to the original question of “Income and Expenses as Cash Basis or Accrual Basis?” is outlined below.
Cash Basis Accounting
Cash Basis Accounting is exactly how it sounds in the name. You recognize the income and expenses when they are received and paid. When the money enters or leaves your account, this is the month and date that the transactions are recorded. This method offers ease of use and improved cash flow. When looking at your financial statements, you will know what is in your bank account at that exact moment, as well as your total income and expenses. This method is more helpful in short-term financial planning.
Benefits of Cash Basis Accounting
- Shorter, quicker learning curve – It is easy to deposit revenue and write expense checks.
- Simplified, familiar process – Cash basis accounting is a simplified bookkeeping process that is similar to how you might track your personal finances. It’s easy to track money as it moves in and out of your bank accounts because there’s no need to record receivables or payables.
- Income taxes – For tax purposes, you don’t have to pay taxes on any money that has not yet been received. For instance, if you invoice a client or customer for $1,000 in October and don’t get paid until January, you won’t have to pay taxes on the income until January the following tax year. For individuals and many small businesses, this can be crucial to keeping your business afloat when cash flow is restricted.
Drawbacks of Cash Basis of Accounting
- Inaccurate financial picture – Since it doesn’t account for all incoming revenue or outgoing expenses, the cash accounting method can lead you to believe you’re having a very high cash flow month, when in reality it’s a result of a previous month’s work.
- No accounts receivable or accounts payable records – Because the method is so simple, it does not require your CPA or bookkeeper to keep track of the actual dates corresponding to specific sales or purchases. In other words, there are limited records available showing your accounts receivable or accounts payable balances, which can create difficulties when your company does not receive immediate payment or has outstanding bills. The financial statements do not show balances to be received or paid in the future.
- Doesn’t conform to GAAP (Generally Accepted Accounting Principles) – If your business were to grow larger than $25 million in annual sales, you would need to update your accounting practices. If you think your business could exceed $25 million in sales in the near future, you might consider opting for the accrual accounting method when you’re setting up your accounting system.
Accrual Basis Accounting
Accrual Basis Accounting is recording income and expenses when they are earned and incurred; this is where the Accounts Receivable and Accounts Payable options come into play. These standards are outlined by GAAP. This method provides a clearer picture of a company’s overall finances since it considers what will be coming in and what will be leaving. This method is also more helpful for long-term financial planning.
The accrual-based accounting method provides a more accurate picture of how much money you earned and spent within a specified time period, providing a clearer idea of when business speeds up and slows down over the course of a business quarter or a full year. Additionally, it conforms to nationally accepted accounting standards. This means that if your business were to grow, your method of accounting would not need to change.
Benefits of Accrual Basis Accounting
- Creates a more accurate financial picture – This can provide you (and your accountant) with a better overall understanding of consumer spending habits and allow you to plan better for peak months of operation.
- Conforms to GAAP – Because the accrual method conforms to GAAP, it must be used by all companies with more than $25 million in annual sales. Since the $25 million sales revenue mark can be high for most small businesses, most will only choose to use the accrual accounting method if their bank requires it.
- Scales with your business – You may not be there now, but in a few short years you could double or triple your revenue, pushing you over the $25 million mark. If you already use the accrual accounting method, there’s no need to change – it simply grows with you.
Drawbacks of Accrual Basis of Accounting
- More resource intensive – Many small business owners find accrual-based reporting more complicated, expensive to implement, and more challenging to sustain the complex back-office infrastructure and additional paperwork. Since a company records revenues before they are received, cash flow is tracked separately to ensure you can cover vendor bills or payroll from month to month. Similarly, the company records expenses before they are due and will need to implement regular accounts payable processes and steps to ensure vendor bills are paid timely.
- Inaccurate short-term view – The cash method gives you a better picture of the funds immediately available in your bank account. If you don’t have careful bookkeeping practices, the accrual accounting method could be financially disabling for a small business owner. Your books could show a large amount of revenue when your bank account is completely empty.
How to Choose Between the Two
Business that would get the most out of a Cash Basis Accounting method would be:
- Sole Proprietors and Small Businesses earning below the $25 million per year restriction.
- Businesses operating without inventory.
- Cash Only Businesses that are not accepting credit or debit transactions.
Businesses that would get the most out of the Accrual Basis Accounting method would be:
- Businesses that accept credit and debit as payment methods.
- Businesses that track customer and vendor transactions, such as Account Receivable and Accounts Payable.
- Non-profits that are currently earning more than $25 million in sales annually that need to ensure proper GAAP compliance.
If you would like to talk to one of our professionals on this topic or any other business-related topic, please do not hesitate to contact a member of our Advisory and Business Consulting team, such as Lindsay Young.