In this blog we go over:
Having trouble deciding whether cash accounting or accrual accounting will work best for your business? Understanding the differences between the two are going to contribute to properly handle bookkeeping needs for your business operations to run smoothly. It’s an important decision to make since if you were to ever want to get it switched, you would have to go through the IRS to process and get approved. Financial GPS is going to break down both methods and the effects of each on different types of businesses to help with the tough decision-making process.
Difference Between Cash Basis and Accrual Accounting
Not all accounting methods are equal, but cash and accrual are the two of the primary methods that the majority of business owners focus on. Cash and accrual accounting are both used for different purposes for different types of businesses. Here are a few of the important differences between these two accounting approaches.
Cash Basis Accounting
Simply put, the cash basis method is when income is recorded when it is received. For instance, when an invoice is recorded on April 1 and the payment is received on May 15, the income would be then recorded as received for the month of May. This is when the money switched hands.
Best for
Small businesses, sole-proprietorships, or partnerships
Businesses that make under $25 million in sales a year (does not conform to GAAP)
Does not sell merchandise directly to customers
Accrual Accounting
Whereas for the accrual method, income is recorded when it is billed and earned. For example, a business bills on April 1, and the funds didn’t clear your account until May 15. With the short-term but accrual method, the billed payment would be recorded income in the month of April.
Best for
Corporations (not S Corp) that averages more than $25 million in gross receipts over the last 3 years (conforms to GAAP)
More long term vision of financial insight
Inventory-heavy business
Advantages and Disadvantages
Cash Advantages
Simple process One of the reasons why small businesses go with this method is due to the straightforward process. It is very much like how personal finances are tracked. Not only is this method easy to track money, but it is also convenient and reliable when it comes to keeping a record of revenue and expenses. This gives a better understanding of the short-term financial situation of the company.
Income taxes The cash basis method definitely is beneficial, specifically when it comes down to taxes. With this type of accounting, “you don’t have to pay taxes on any money that has not yet been received” (Intuit). This guarantees that your business’s cash flow will progress and have accessible cash for when tax payments come around.
Cash Disadvantages
Inaccuracy, because of the simplified process With the straightforward cash method, it does not take into account all the incoming revenue or outgoing expenses. With that said, this method can influence the perspective of cash flow. It may seem that the current month has high cash flow, but in actuality, it is from the previous month’s performance.
No A/R or A/P records Furthermore from the last point, because the process is simple, there are no records of accounts receivable or accounts payable. This can ultimately lead to complications when the business does not receive immediate payment or has outstanding bills.
Accrual Advantages
Accuracy, more useful business analysis Although this accounting method is complicated, it gives business owners a more accurate idea of income and expenses during a specific period. An analysis of this helps business owners (and their accountants) understand consumer spending patterns.
Easy planning Having this process being easier can be essential for certain business operations such as inventory, staffing, etc.
Accrual Disadvantages
More complicated needs more time and resources Compared to the cash method, accrual accounting is more intricate since it is better for the long-term view of the company’s financial situation. As a result of the business recording revenues before actually receiving the cash, the flow of cash will have to be recorded independently. Similarly, the effect on taxes (income taxes) may be owed on revenue before payment is received. Hence, there is more work on the accrual method.
Inaccuracy, for the short term view Yes, the accrual method provides accurate long-term value, but cash is the better method for reviewing the funds in the bank account. Why is this? Since there’s money that has yet to come in and be received, it’s unclear.
The Decision
Although the accounting method and financial reporting system that's chosen for the business is ultimately an administrative decision, the business goals, accessible funds, and financial limits should all be considered when deciding. As long as the business makes more than $25 million in gross annual sales, the two options are freely available to take into account. So once again, study the advantages and disadvantages, as well as reflecting on the business’s needs. If you are still unsure what the best decision is, talk to a CPA or contact a tax professional.