Running a business means dealing with bookkeeping and accounting. There are two ways of accounting: cash basis accounting and accrual accounting.
Here are the differences between the two methods, examples of each, and the pros and cons of both methods.
As stated by Investopedia:
The main difference between accrual and cash basis accounting lies in the timing of when revenue and expenses are recognized. The cash method is a more immediate recognition of revenue and expenses while the accrual method focuses on anticipated revenue and expenses.
That is the most simple of terms, but here is a more in-depth look at each method of accounting.
Cash Basis Accounting
For personal finances and small businesses alike, this is a popular way of accounting.
How it works is that you record expenses, but only when paying outbound cash. As far as reporting revenue, when you receive cash, you then report it.
An easy example is that when money comes in, you record it, and when money goes out, you record that as well. You do not count invoices or monies not yet received.
This is a cash-only type of accounting for your business. Some people find this the most simple way of keeping up with money, and its ease of use makes it popular for some businesses.
Examples of Cash Basis Accounting
Here is an example using a photography business. You do not record any received earnings until you receive the payment. The same thing is applicable for tangible items you sell.
Whether you sell office equipment or farm machinery, record the earnings as it comes. The money must change hands or you have a payment in your possession in the cash basis method.
With expenses, the same thing applies. If you pay for a power bill at your photography studio, you do not count that expense until you actually pay it.
Advantages of Cash Basis Accounting
One of the major advantages of cash basis accounting is its simplicity. Keeping up with the cash flow is simple. You only count money that you have received or money that has gone out, so there is less room for mistakes. Also, cash is more flexible.
As stated at Forbes:
Cash is potential buying power and provides the manager with flexibility when conditions change. It may not be a profitable strategic asset for the long term, but it is an underrated risk mitigation tool for active managers in the short and medium term. As the cycle progresses further, volatility will likely pick up and the usefulness of cash as a tactical asset will likely increase.
Disadvantages of Cash Basis Accounting
With this type of accounting, there are a few disadvantages. For instance, when accounts payable are higher than the amount of cash on the books, there is more value. But, the company may not have that value shown. This lower revenue is misleading to investors. This is because they think that the company is more successful than it is.
Accrual Accounting
This form of accounting involves recording revenue when you earn it. This means that even before money moves from one party to the other, it is recorded. For example, when you sell a product or deliver a service, you record the amount. This is in expectation of a payment in the future.
For expenses going out, you record those as you pay them as well. With this accounting method, there is an easy way to understand it.
For bills you need to pay or invoices you need to send, count those before you pay them or debit them.
Examples of Accrual Accounting
With accrual accounting, count the earnings for the photography job as soon as you book it. This is in expectation of a future payment. So, if a client books a job for the upcoming month, you would count those earnings now and record them as revenue. For expenses, the same applies. If you have to pay the rent on your studio, record that expense before you receive payment.
Advantages of Accrual Accounting
Cash is a disadvantage when it comes to showing the true value of the company’s revenue. Yet, with the accrual method, this becomes an advantage. Using the accrual method shows an accurate snapshot of the company’s true revenue.
Investors see that the company is making a profit, because you record revenues and expenses. Since this happens immediately, the revenue and expenses show data.
This is not as transparent with the cash basis accounting method.
Disadvantages of the Accrual Accounting Method
One of the disadvantages of the accrual method is it is difficult to keep up with unearned revenue. Prepaid expenses are also harder to track.
This does not mean that the accrual accounting method complicates things. It is not as simplistic as the cash method of accounting.
Another one of the disadvantages is that cash flow is not tracked, which can lead to a shortage of cash. This is even if the company looks profitable on paper.
How Both Methods Effect the Bottom Line in Accounting
Here is an easy scenario of how both methods affect the bottom line. Let’s say your business has the following transactions within a specific month:
- You send out an invoice for $2,000 for an advertising project.
- You receive a bill for $500 for freelance work.
- Your company paid $50 in fees for a prior bill.
- You receive $1,000 from a customer who paid an invoice from the previous month.
With the cash basis method, the profit is $950. This is for the $1,000 the customer paid, minus the $50 paid back.
Using the accrual accounting method, the profit is $2,450. This is the $,000 invoiced, minus $50 in fees, and plus the $1,000 invoice paid by the customer for the previous month.
Each method is correct in how you use it, but the accrual method shows more of a profit. The cash method shows the actual cash on hand.
Both methods are helpful depending on which is easier for your company and which you prefer to use.
How to Choose the Right Method for Your Company
When choosing an accounting method for your business, pick one that works best and stick with it.
In fact, the IRS requires that you do so as stated in the accounting methods section of Publication 538:
You choose an accounting method when you file your first tax return. If you later want to change your accounting method, you must get IRS approval.
One of the differences between cash basis accounting and accrual accounting is taxes. Each affect the year recorded in different ways.
For example, with the cash method, a December transaction is for the same month it took place. Using the accrual method, an invoice in December paid in January goes on the previous year’s taxes.
With this method, you will pay taxes for the prior year’s income even though payment is in January.
Both methods are ideal depending on which one you prefer and the goals of your company.
Both have their advantages and disadvantages. The important thing is to have knowledge of how each method works when making decisions.
An important thing to keep in mind is that the Internal Revenue Service has requirements. Some business must use the accrual method of accounting instead of the cash basis method.
Those who fail the Gross Receipts Test for Qualifying Taxpayers must use the accrual.
You can find out more about limitations on use of cash accounting at Cornell Law School’s Legal Information Institute.
Schedule a free consultation with Founder’s CPA today!
