It is all about the timing, baby! In a nutshell, accrual basis accounting simply means that revenue and expenses are recognized when they occur. Cash basis accounting means these items are not recognized until the actual cash exchanges hands.
However, the decision on which method to use is a very important one to make for all businesses. It is one of the first major accounting decisions you will need to make. Depending on your needs and your business needs, you will need to choose one of these methods to keep track of your money.
Accrual Basis Accounting
Accrual basis accounting is a method of accounting that records revenues and expenses as they are earned regardless of when you receive or pay this money. For example, a company hires you to do a graphic art project for them. You do the work, present it to them, and give them the invoice. At this point, you would record that as revenue earned (accounts receivable) even though you have not been paid. The same thought process goes that if you receive an invoice from another company, you would mark that as money that will be paid (accounts payable).
Accrual basis accounting is more commonly used as opposed to cash basis accounting especially with larger companies and publicly traded companies. Accrual basis accounting gives a more realistic idea of income and expenses over a period of time, thus enabling you to view a longer-term picture of your business. Cash basis accounting cannot provide this.
The biggest downfall of accrual basis accounting, however, is that it does not provide a clear awareness of immediate and day-to-day cash flow. A business can easily appear to be very profitable using the accrual basis accounting method, while the bank account is empty. Accrual basis accounting must be carefully monitored to avoid cash flow problems that could potentially have devastating consequences.
Cash Basis Accounting
On the other hand, cash basis accounting recognizes revenues and expenses when they are received. This method does not recognize accounts receivable or accounts payable, so that is one less step to think about. Many small businesses opt to use cash basis accounting when they first start out because of its simplicity. It is easy to maintain and easy to understand. Basically, it is money in/money out. You can easily monitor when a transaction occurs and whether that transaction represents money being spent or revenues coming in.
Cash basis accounting is beneficial in terms of tracking how much cash the business has at any given time. You can easily look at your bank balance to see exactly what resources you have available at any given time. Since the transactions are not recorded until the cash is received or paid, the business income is not taxed until it is in the bank.
A downfall to cash basis accounting is that it can be difficult to manage. This is because it depends on when your customers pay you instead of when you do the work. For example, let’s say you provide services on an hourly basis to your customer and bill them after the end of the month. You still have to pay your employees in the month the professional services were provided. However, you will not recognize the revenue until the customer pays you. This creates a mismatch between your revenue and your cost and makes it harder on a monthly basis to assess how you are doing and what you can be doing better.
Another thing you need to consider when you are making this decision is taxes. The IRS has specific rules and guidelines that must be followed when you choose one method over the other. Under cash basis accounting, you generally report the income in the tax year you receive it and deduct expenses in the tax year that you pay the expenses. Under, accrual basis accounting, you report the income in the tax year you earn it regardless of when you actually receive payment. The same process would relate to expenses. You would record your expenses when they occur, not necessarily when you pay them.
It is all about timing and what your business’ needs are. It’s not uncommon for a business to start out using the cash accrual accounting method based on its simplicity and the need to strictly monitor cash flow. When a company grows, they may find the need to switch accrual basis accounting. This is where the services of a good accountant/CPA are invaluable. There are specific processes that must be followed, but it is possible to change methods.
We cannot stress how important it is to invest in the services of a good accountant to help you navigate these waters! Would you like to know more about how outsourced accounting with Accounovation can help your business thrive? Please contact us for more information.