One of the first decisions a new business needs to make is which accounting method they will use to record their financial transactions. To make this decision one first must know the differences between cash accounting and accrual accounting. (Which are sometimes also referred to as the cash basis and the accrual basis.) Accounting methods are some of the most important, yet most commonly misunderstood principles of accounting, so let’s break them down.
What are the differences between cash accounting and accrual accounting?
The main difference between cash and accrual accounting regards the timing of recording transactions. In cash accounting, financial transactions are recorded once cash is exchanged. In accrual accounting, however, financial transactions are recorded at the time the revenue and/or expense is earned/incurred, regardless of when money is exchanged.
For example, say you operate a landscaping business. In January you mow a lawn for a client, but they don’t pay you for the service until February. In cash accounting, you would wait until you receive the cash in order to record it, meaning you would record the transaction in your February books. In accrual accounting, however, you would record the transaction the moment the service is rendered; You would record the transaction in your January books.
What if the situation is reversed? What if a client pays for a service before you have provided it? The same rules apply in this scenario. Say you were paid to mow the lawn in January, but you didn’t complete the service until February. In cash accounting, you would record the transaction in your January books, because that’s when you received the cash. If you are using the accrual method, you would record the transaction in February, because that’s when the service is completed.
The same is true regarding expenses. In accrual accounting, you record the expense the moment you incur it. Say you buy a new lawn mower in January, but you bought it on credit and don’t need to pay until February. In cash accounting, the expense would be recorded in February, whereas in accrual accounting, the expense is recorded the moment it is incurred, or rather, in January.
The other major difference between cash and accrual accounting is the types of transactions recorded. In the cash method, only the transactions regarding money exchanged are recorded. However, in accrual accounting, you record all transactions related to the business.
What are the benefits and disadvantages of the different methods?
Because there are fewer types of transactions to record, the cash method is much simpler and cheaper than the accrual method. It is easier to maintain and easier to understand. Another advantage of this method is you always know how much cash is available to you at any given moment. However, while the accrual method does require more work, it provides better financial insights and more accurate reports about the long-term health of your company. In cash accounting, you don’t necessarily track your assets, liabilities or equity. Meaning unless you take steps to monitor them, you may have no way of generating reports about your company apart from cash flow. (But don’t worry, we can easily do this for you!)
Another disadvantage of the cash method is it can sometimes lead to false conclusions about your profitability. Let’s go back to our landscaping business example. Here’s an imagined list of revenue/expenses for January and February.
- Billed customers for 5,000 in services completed in January
- Received payments from customers 1000
- Purchased new equipment on credit 800
- Billed by outside contractors 1000
- Paid outside contractors 700
- Received 4,000 in payments from customers
- Paid credit card bill 800
- Paid outside contractors 300
These charts, while representing the same transactions over the same period, present two very different scenarios. If you looked at the cash chart, you would think February was your more profitable month. In reality, you didn’t earn any income at all in February, but rather collected payments for services already rendered.
As you can see in this example, the accrual method is a more accurate depiction of how your company is actually performing. Still, there are downsides to the accrual method as well. For example, because you are recording transactions when the services occur as opposed to when the money actually comes in, your books won’t match your bank statements. Additionally, you will be unaware of what your cash situation is. This can be disastrous for a business if you aren’t monitoring your cash flow in other ways. You may end up short on cash without realizing it and be unable to pay your bills, even though the long-term health of your company is stable.
How do the cash and accrual methods affect my taxes?
It’s important to decide early on which method you want to use because the IRS requires individuals and businesses to file their taxes using the same method each year. In other words, once you file one way you have to file the same way each year. Later if you wish you switch methods, you have to file a special request with the IRS.
The method you choose can also have an effect on your year-end taxes. If you use the accrual method, for example, you may end up paying taxes on money you haven’t actually received. For example, if you use the accrual method and you invoice a service in December 2017 for 1,000, but you don’t end up receiving the money until later, the transaction would still be recorded as part of your 2017 taxes. Therefore, another cash method benefit is that you don’t pay taxes on any income until you actually receive the money.
What method is right for me?
Most individuals and small business use the cash accounting method. This method is much simpler and faster than accrual accounting. If you don’t have a lot of accounts receivable or accounts payable, the cash method may suffice for your business. Especially if you are a business with a lot of cash transactions and are dealing with customers directly, the cash method may be right for you.
If, however, you are a larger business and you don’t get paid quickly, accrual accounting is probably your best option. In fact, the IRS requires certain types of business to use accrual accounting. If your company makes more than five million in revenue, for example, the IRS requires that you use accrual accounting. Additionally, if you are audited, the process will be a lot easier if you use accrual accounting because you have detailed reports about every financial transaction you’ve made.
There you have it, the basic differences between cash accounting and accrual accounting. Still unsure about which method is right for you? Contact us now for a free initial consultation! Want to learn more? Check out our YouTube channel or our blog for all kinds of great accounting, bookkeeping, and business tips.