Cash based vs. Accrual based accounting - Which one is right for you?

Even if you’ve hired someone to handle the bookkeeping (something we recommend outsourcing to avoid burnout), understanding the difference between cash-basis and accrual accounting is incredibly important. The key difference is when transactions are recorded in your books. Whether you choose to do one over the other is (mostly) up to you. But understanding how they work, the benefits and limitations to each method, and how it will affect your business could save you money and an audit from the IRS.

Cash-Basis Accounting

What is it?

Cash basis accounting method records transactions when money actually changes hands. This means you record the sale of your service when you receive payment from the customer, not necessarily when the services are rendered. The same goes for purchases. You don’t record your expenses until you pay for them.

At first glance this seems pretty straightforward, but what happens when the plumber comes by to fix a leaky pipe and you don’t have to pay him for 30 days? You know you’re going to owe them money, but you don’t record the transaction until you give pay. It doesn’t matter that the work is already done and the pipe has been fixed for three weeks. Don’t record it until you pay for it.

Who uses Cash Basis accounting?

Cash basis accounting is great for small businesses, sole proprietorships, and small groups of partners because it’s simple. When cash comes in, you record it. If you pay for something, you record it.

Pros  

• Because it’s simplistic and transparent, it’s fantastic for monitoring cash flow. At any point in time if you want to know how much cash you have on hand, just look at your bank statement.
• Another great benefit is that you don’t record revenue until it’s in your hand so you aren’t taxed until it’s in the bank. This eliminates the chance of paying tax this year on money that’s owed to you next year like you would with accrual accounting.

• cash basis accounting does come with limitations.
• doesn’t allow much flexibility or provide you with the whole financial picture.
• As your business grows, you may find a need for making purchases on credit or selling services on store credit to your customers. Many businesses need to do this either for cashflow purposes or the ease of doing business with other vendors.
• Cash basis accounting doesn’t allow you to record or track anything owed to others (accounts payable) or what others owe you (accounts receivable).

Because you can’t track what’s owed to you or purchases made on credit with the cash basis method, it also doesn’t provide you with a complete picture of your finances. It does a poor job of matching revenue earned with money paid for expenses.

For example: You purchased $500.00 of merchandise in November. You didn’t sell the merchandise until December. This means you received $1000.00 in revenue in December, not November when you incurred the $500.00 expense. Because there’s a delay between when you incurred the expense and collected the revenue generated by that merchandise, you have no revenue to offset the cost in November. So, for November, your financial statements say you took a loss of $500.00 and in December you made a profit of $1000.00, which isn’t accurate. In reality, you made $500.00 profit, but because cash basis accounting doesn’t match revenue earned with expenses, it’s a little thrown off. In this case, the books reflect poor decision-making in November and excellent decision-making in December; neither of which are true.

Can you use Cash Basis accounting?

Can you use Cash Basis accounting? If you answer ‘yes’ to either of these questions, you cannot use cash based accounting:

1. Does your business sell products on store credit and bill on a later date?
2. Do you purchase supplies or goods on credit to be paid later?

Accrual Based Accounting

What is it?

The Accrual Based method records transactions in the books at the time of contract or agreement rather than when cash is actually exchanged. A key guideline for the accrual method is called the matching principle. This states that an organization must report an expense on its income statement in the same period as the related revenues.

Essentially, it allows more flexibility to do things you couldn’t do with the cash basis method. For example, purchasing merchandise from vendors on net 30 credit account or offer store credit to customers. It also gives the company a more accurate understanding of the business financials at any given time. How? It accounts for the cash going in and out today as well as cash to be paid or received in the future.

Who uses the accrual method?

Most businesses use the accrual method except for many individuals and small businesses which often use the cash basis method.

Pros and Cons

Pros  This method gives you a good indication of your business's health; such as how many sales you’ve completed, how much revenue you’re expecting and how much money you owe.

Cons  The accrual method is more complicated than the cash method. It requires more recording, adjusting and financial housekeeping. Since it considers future cash flows, it doesn’t give you a clear understanding of cash on hand. You’ll need to either find another manual method to keep track of cash flow, or use a business software to help simplify it. Also, if you’re considering making a shift from cash basis accounting, know that tax burdens can be difficult to navigate as well.

Should you use the accrual method?

Should you be using the accrual method? If you answer ‘yes’ to any of these questions, then you need to use the accrual method:

• Does your business generate more than $5,000,000 in revenue annually?
• Do you have merchandise inventory?
• Do you make business purchases on credit?
• Do you offer store credit to vendors or customers?

It’s good to understand the different ways for your business to handle accounting. Depending on your size you may not have the option to outsource managing the books. If you do have the option, we highly recommend it. Simplify what admin tasks you own, so you can focus on your clients and making your business successful.