Understanding Cash-Basis Accounting vs. Accrual-Basis Accounting
When most folks start their business, they might spend a lot of time thinking about the name of their company, their logo, and what products and services they’ll provide. There are a lot of upfront decisions that need to be made. Another consideration that often gets overlooked is what accounting method the business chooses. There are two different types of accounting methods: cash and accrual accounting.
The main difference between cash and accrual basis accounting is how to record sales and purchases in financial accounts. In cash accounting, revenue and expenses only get recognized when money leaves or enters the account - when the cash actually moves. With accrual accounting, revenues and expenses get recorded when earned or billed. So if you send an invoice to a client today, but the client doesn’t pay until sixty days after the invoice was sent, revenue gets recorded differently based on the accounting method. When you get paid under cash accounting, you don’t record the payment until it’s received, but with accrual, the revenue gets recorded (as accounts receivable) when you send the invoice.
Let's take a deeper look at both methods, their advantages and disadvantages, and how to select the suitable method for your business.
What is the Cash Basis of Accounting?
Cash basis accounting is a simple accounting method. As mentioned earlier, under this method, revenues and expenses are recorded when the cash gets exchanged. The transactions get recorded using single-entry bookkeeping.
Cash basis accounting is most suitable for tax purposes in public companies such as sole proprietors, partnerships, and S corporations.
Pros of a Cash Basis System
Easy to Use
The cash basis method is straightforward, easy to learn, adapt, and implement for most business people.
Since fewer bank accounts need tracking throughout an accounting period, the data is minimal. So this eliminates the need for elaborate cash account planning or complex analysis.
Cost-effective
Due to this simplicity, this method is more cost-effective, time-saving, and requires fewer resources such as labor.
Cons
The cash basis accounting method has substantial benefits, but there are some downsides as well, such as:
Inaccuracy
When using the cash basis method, a business will have a limited perspective on revenue and expenses. Since liabilities aren’t being counted within the monthly accounting cycle, determining the business's profitability can require additional steps and monitoring. You may end with the wrong perception of how much money you have at hand.
Additionally, the cash basis method gives only a partial picture of a business’s financial health and what to expect in the future. This limitation affects how critical financial decisions occur. For example, business expansion and hiring new team members.
Limited Usage
Some businesses are not allowed to use the cash basis accounting method. Such companies provide:
· Offer any products or services on a credit basis
· Require inventory to account for revenue
· Handle gross receipts that exceed the IRS requirements
· Are partnerships or C corporations with average annual gross receipts of above $25 million in the past three years
Businesses that extend credit to their customers should use the accrual method. Due to credit, you need to record transactions as they happen to help monitor creditors with balances.
Difficulty in Switching
As a business expands, revenue and expenses increase. The increasing transactions prompt the decision to switch to the accrual accounting method. The change requires some adjustments, which can be challenging to implement.
For instance, you'll need to include all pre-paid and accrued expenses and accounts receivable. You'll also need to deduct all customer prepayments, cash receipts, and cash payments. Before you switch, you're required to submit a formal request with the IRS by filing the Application for Change in Accounting Method or Form 3115.
What is the Accrual Basis Method of Accounting?
The accrual basis accounting method monitors revenue and expenses when they happen. The figures are then recorded automatically in the business's financial statements. It’s more complex than the cash basis method, but it gives a more accurate perception of the exact time of expenses and profitability.
For instance, if a sale happens in August but the payment reflects in September, the revenue will be under August. If the business pays for an asset in August but receives it in September, you can record the transaction as a pre-paid expense depending on the cost and its policy. If you’ve ever ordered a pizza from Domino’s and seen their real-time pizza tracker, the accrual accounting method is kind of like this because it allows you to know how money is moving through the business because it records income and expenses at different stages.
When using the accrual accounting method, you’ll need to make the entries before closing the month’s finances. You’re able to record revenue in the correct period and account for expenses incurred during this period. This practice is necessary, whether the payment is complete or not.
This accounting method facilitates a more accurate financial analysis of the business's performance. It’s arguably better than the cash basis method, but it’s much more intensive. You’re able to predict monthly operational expenses for better planning.
The accrual basis accounting method is most appropriate for;
- Businesses that operate using double-entry bookkeeping
- Those that offer products or services on credit
- Small businesses looking to expand, apply for a loan, or find investors
Pros of Accrual Accounting
Better Business Analysis
Matching revenue and expenses enables you to carry out significant business analysis. You’re able to:
- Get an overview of the benefits of business assets
- Overview of the costs incurred through maintenance, and
- The revenue generated from these assets
Better Financial Planning and Forecasting
Accrual accounting allows you to better plan and account for all revenue and expenses during a specific period. You're able to create more accurate expense budgets and plan for sales to ensure smooth business operations.
This method also helps businesses to create financial statements at the beginning or end of the year. These reports offer insightful information that guides financial decisions. The data also helps;
- Determine the specific products or services that are best performers
- Determine those that are improving, and
- Determine those that need re-evaluation in the future
GAAP Compliance
When you use the accrual method, the expenses and revenue match. This does not affect financial statements by the timing of cash during business negotiations.
The financial statements are more realistic of the business’s financial position. Although small businesses don’t need to comply with GAAP, as they expand, it becomes inevitable.
Cons of Accrual accounting
Unpredictable Cash Flow
In accrual accounting, transactions get recorded as they happen, not when the funds reflect. The method gives a false impression of profitability wherein an absolute sense; the funds are not there.
Complex Calculations
Accrual accounting requires compliance with multiple rules and regulations. Compared to the cash basis method, the accrual accounting method is more complicated.
Bookkeeping helps you to avoid mistakes that would lead to incorrect revenue and expense calculations.
Requires Professional Services
Accrual accounting has many benefits. However, it requires professional accounting practices for efficient management. This is a challenge for small businesses that don’t have adequate finances to hire a professional.
Requires Frequent Reporting
For accrual accounting to be accurate, reports, such as monthly financial statements are necessary. Accounts payable and receivable are even more frequent.
Higher Annual Tax Rates
Accrual accounting records revenue generated at the point of sale rather than when the payment comes in. This means businesses end up paying taxes for the income they have not received.
Comparing Cash Basis Accounting and Accrual Accounting
Accrual accounting is a more accurate and realistic method to measure how the business is performing. Cash basis accounting is more straightforward. It doesn't need to align with the Generally Accepted Accounting Principles (GAAP) guidelines or the International Financial Reporting Standards (IFRS).
Cash basis accounting only records transactions when funds come in or out. Accrual accounting, on the other hand, records transactions when they take place. It’s a summary of financial transactions and recognizes only the actual payments. Accrual accounting offers a more comprehensive perspective and recognizes financial obligations.
How to Choose the Best Accounting Method for Your Business
Consider Your Income
The cash basis accounting method is only appropriate for businesses that earn $25 million and less per year. If your business’s revenue is above this amount, the IRS expects you to implement the accrual method. If not, you have the freedom to choose which way is most appropriate for you.
Consider Your Business Goals
When selecting a suitable accounting method, it's essential to consider your future strategies. If you project gross annual sale revenues above $25 million, consider adopting the accrual method.
Internal or External Reporting
The reporting method plays a part in deciding the most suitable way, cash basis or accrual basis. If your goal is cash management and you already have a cash flow foundation, the cash basis method is best.
If you require bank transactions, financial audits, or you’d like to apply for financing, consider adopting the accrual method.
Conclusion
Both accrual and cash basis accounting methods have benefits and shortcomings, but neither provides a complete overview of a business's financial position. However, the accrual method is more popular. It records all revenue and expenses, unlike the periodic recording offered by the cash basis method.