Cash Basis Accounting vs. Accrual Accounting
The choice of cash vs. accrual is one of the first choices new business owners have to make. Accounting is vital for managing business finances and staying afloat. Here is a closer look at accrual accounting vs. cash accounting to help you make the right decision.
The Difference Between Cash And Accrual
The critical difference for cash basis vs. accrual basis is when businesses record their purchases and sales into their business accounts. Cash basis accounting takes note of expenses and revenue when money comes into – or leaves – a business account. Accrual basis accounting registers revenue whenever it’s earned. Expenses are tracked whenever billed, even if it hasn’t been paid yet.
One part of understanding accrual accounting vs. cash accounting is understanding what “recording transactions” means.
Every business should record financial transactions in a ledger. This process is known as “bookkeeping.” Every business needs to do this to track income and outcome and identify potential tax deductions come tax time.
Every business should also have a central hub to track all expenses and income and add everything up. This information helps you file your taxes and stay on top of your current financial situation.
Cash Basis Accounting
Cash basis accounting recognizes revenue whenever businesses receive cash. Any expenses are recognized when those expenses are paid. Cash basis doesn’t account for accounts payable and accounts receivable.
Small businesses choose cash accounting over accrual accounting because cash accounting is easier to do and maintain. Cash basis accounting makes it easier to understand when transactions happen as it records when money comes into your bank account or comes out. This accounting method doesn’t require tracking payables and receivables, which makes it easier to track revenue.
Cash accounting offers some benefits, such as making it easier to track how much money a business has at a given moment. Check the bank balance to quickly understand how much money and other resources you have to hand.
Given that cash accounting doesn’t record transactions until money changes hand, business income isn’t taxed until the business has it to hand.
Accrual Basis Accounting
Accrual basis accounting is when a business record expenses and revenue when the money is earned, even if the money involved hasn’t changed hands. For example, businesses would record income upon project completion instead of when they get the money for the project. The accrual method is used more commonly than accounting with a cash method.
The benefits of using accrual basis accounting are that accrual basis accounting offers a better picture of business income and business expenses over a set period. This method provides a more long-term view of how much cash a business has that you don’t get from cash basis accounting.
One of the downsides of using this accounting method is that it doesn’t offer awareness of current cash flow. Your business may seem profitable when the reality is that you don’t have much money in your bank account. Companies that use accrual accounting should carefully monitor how much cash flow they have to avoid potentially severe consequences.
The Effects of Cash and Accrual Accounting
You must understand the differences between using cash vs. accrual accounting. One way to do this is to put things into context and see how each method affects your business and finances.
Let’s look at both types and see an example for how they affect the business bottom line.
Let’s say that your business performs these transactions across a month;
- You send an invoice for $4,000 to a web designer for their work
- You receive a bill for $1,000 for work completed
- You pay $75 in fees on a bill received in the previous month
- You receive $1,000 from clients for projects invoiced the previous month
The Effect on Cash Flow and Taxes
Let’s take that example and see how the cash and accrual method affects cash flow and taxes.
- Cash Flow
Your business would make a $925 profit with the cash basis accounting method – $1,000 income minus the $75 fees.
With the accrual method, you would account for $3,000 in profit – $4,000 in income minus the $1,000 in developer fees.
This simple example shows how the different methods offer different views of your cash flow.
Let’s take that earlier example and say that it happened between November and December 2019. Another difference between the two accounting methods is how they affect the tax year you record expenses and income when doing your taxes.
With cash accounting, your business records expenses and income when received. Accrual accounting records income when earned.
With accrual accounting, if you invoiced a client $4,000 in December 2019, the transaction would get recorded as income generated in 2019 and have to pay taxes on it that year, even if the money doesn’t come into your account until January 2020.
This means that you are paying taxes on the money you don’t have yet. This could present a problem if you don’t have as much money as you think. With the cash method, you only register transactions when you receive or make them, giving you an even playing ground during tax season.
Should a Small Business Use Cash or Accrual Accounting?
The decision of whether you use accrual or cash accounting might not be up to you. The IRS requires all businesses – other than S corps – that make over $25 million gross in the prior three years to use accrual accounting. You can account with the cash basis method if you don’t meet those requirements.
With that said, cash accounting works better with small businesses with a small inventory. If your company has a lot of stock, you should consider using accrual accounting. Remember that if you change your accounting type, you’ll have to get permission from the Inland Revenue Service (IRS). Changing accounting type requires you to file Form 3115.