As a founder, operations, or finance manager, you’ll be faced with a myriad of pivotal choices on a daily basis. However, deciding between cash and accrual accounting methods is a critical decision that will have far-reaching implications.
Your choice between accrual vs cash will affect your business in several ways. First, it will demonstrate different things to potential investors. Second, it will modify the timing of your tax liability for earnings and when you can declare expenses. Third, it will influence your capacity to forecast and budget with precision.
You may have many questions as you face this decision. For instance, why is it essential to select between cash vs accrual accounting methods? What sets cash and accrual accounting approaches apart? Additionally, what does “accrual” denote when it comes to accounting? In this blog post, we hack through the weeds to give you the information you might be seeking.
Brief explanation of cash vs accrual accounting
Cash accounting and accrual accounting are two different methods of recording financial transactions. The key difference between the two lies in the timing of when transactions are recorded.
Cash accounting records transactions when cash is received or paid. This means that revenue is recognized when payment is received, regardless of when the sale was made. Similarly, expenses are recorded when payment is made, irrespective of when the expenses were originally incurred.
On the other hand, accrual accounting recognizes revenue when it is earned, regardless of when the payment is actually received. Likewise, expenses are recognized when they are incurred, irrespective of when the payment is made. Therefore, under accrual accounting, revenue and expenses are recorded in the same accounting period as the associated transactions, regardless of whether payment has been received or made.
Why is it important you choose the right method?
The accounting method you choose can have a big impact on your finances, taxes, and business success. When making this decision, consider factors like business type, revenue, sales types, and IRS requirements.
For example, service-based businesses may benefit from the simplicity of cash accounting, while inventory-based businesses may find accrual accounting more suitable.
Revenue and sales also can help determine the appropriate accounting method. Cash accounting recognizes revenue when payment is actually received, making it suitable for businesses with steady and immediate cash flows. On the other hand, accrual accounting records revenue as soon as it is earned, irrespective of payment timing. Businesses that extend credit to customers or have long-term contracts are best suited for it.
Finally, IRS requirements dictate when a business must use accrual accounting. For instance, if your annual gross receipts exceed $25 million, you are generally required to use the accrual method.
What Is Cash Basis Accounting?
The key principle of cash basis accounting is the recognition of transactions only when cash is exchanged. This means that revenue is not recognized until the cash is actually received, and expenses are not recognized until the cash is actually paid. Small businesses often use this simple method of accounting as it provides a straightforward way of tracking cash flows.
A business that operates on a cash basis will record revenue and expenses as it receives cash or pays it out. For example, in November, you deliver $1000 of product to your customer, BrightStar Technologies. Brightstar pays you the same month, and you record that $1000 as November revenue.
If you deliver to Brightstar in November and receive payment in December, you would treat it as December revenue. The revenue for this delivery will not appear on your books until the money has appeared in your account.
This approach also applies to expenses. If you paid a supplier $500 in November, it goes into the books for that month. However, you may receive a shipment from a supplier in November but not pay them until December. In that case, that payment is now a December expense as far as your accounts are concerned.
While cash basis accounting may be simpler, it may not accurately present a company’s overall financial position. It is still widely used by small businesses and individuals due to its simplicity and easy implementation.
What Is Accrual Accounting?
The key feature of accrual basis accounting is its focus on matching revenues and expenses to the period in which they are earned or incurred. This means that even if the cash for a transaction is received or paid in a different accounting period, the transaction is still recorded in the period when it actually occurred.
Businesses often prefer to utilize the accrual accounting approach since cash accounting does not consider forthcoming expenses and revenue. Selecting the accrual accounting method implies that revenue and expenditures are recorded as earned or incurred instead of when they are received or paid out.
For instance, if your business supplies $1000 worth of products to BrightStar in November, you will record it as November revenue, regardless of when you actually receive the payment. Similarly, the $500 shipment from your supplier would be considered a November expense, even if the payment is not made until December.
What Does Accrual Mean in Accounting Terms?
An accrual is a term in accounting for the accumulation of revenue or expense transactions. The company has recorded them in the accounts, but they haven’t yet received revenue or paid the relevant bills. These transactions represent revenue your company expects to receive or a bill it will have to pay in a future period.
A company records revenue and expense accruals in separate accounts known as ‘accounts receivable’ (for revenue) and ‘accounts payable’ (for debt).
When your company receives customer payment, your total accounts receivable will decrease as your bank account increases. Similarly, your accounts payable balance will decrease as your company pays the outstanding bills.
Impact on financial statements
When it comes to financial statements, deciding between cash vs accrual accounting is like choosing between two different paths with big consequences. Cash accounting records cash transactions only, while accrual accounting recognizes revenue and expenses when earned or incurred, regardless of cash flow.
Cash accounting shows current cash inflows and outflows, showing immediate funds availability. It helps assess a company’s ability to meet short-term obligations. Accrual accounting captures revenue and expenses that have been earned or incurred but not yet received or paid. This method provides insights into overall financial health and a more accurate picture of profitability over time.
Cash accounting is considered to be more conservative in terms of profitability compared to accrual accounting. This is because revenue is only recognized when cash is received, which may not fully represent a business’s true profitability, particularly for companies that offer credit terms. Accrual accounting, on the other hand, provides a more comprehensive perspective by recognizing revenue when it is earned, regardless of cash flow.
Examples of Accrued Revenue and Expenses
It might be hard to conceptualize when the difference between cash vs accrual accounting matters. There are several standard examples a business owner might come across.
- Transactions on Credit: This doesn’t mean payments with a credit card. Instead, if you buy or sell goods and services with a payment date after receipt, you have made a credit transaction.
- Advance/Late Rent Payment: In the case of rental payments, you would always record the expense when rent is due, not when you pay it.
- Interest on Time Deposits: Even though you can’t access the interest earned on time deposits in the year it’s earned, it’s still recorded as income.
- Insurance Premiums: If you have an insurance policy that doesn’t begin at the beginning of the year, you’ll record prorated amounts across the two tax years, even if you pay the full year in advance.
Cash vs Accrual Accounting: Pros and Cons of Cash Basis
As with any decision made by a business owner, there are advantages and disadvantages to both the accrual and cash basis accounting methods. In this section, we will explore the pros and cons of cash accounting.
Pros of Cash Accounting:
- Easy Identification of Transactions: Identifying which transactions to record is straightforward. If a transaction did not increase or decrease your bank account, it is unnecessary to record it.
- Simple Error Checking: With cash accounting, businesses only need to monitor their bank accounts, making it easy to detect any underpayments from customers or similar issues.
- Tax Benefits: Cash accounting allows businesses to delay paying taxes on income until it is received, giving them more control over their cash flow. Additionally, businesses can accelerate tax deductions by paying expenses in advance, reducing their taxable income.
Cons of Cash Accounting:
- Budgeting Challenges: Large payments appear in lump sums, making it challenging to budget across time periods. For instance, if you received $500,000 from Brightstar, with the full amount recorded as November revenue, it represents an upfront payment for a monthly shipment of products for the next 12 months. The associated costs would be recorded each month as they were incurred. From December onwards, the Brightstar account would show a monthly loss.
- Difficulty in Attracting Investors: Investors require an overall picture of the company they intend to invest in. This includes an accurate understanding of what the company owes, how much it expects to earn over the next 12 months, and how much it expects to spend. Companies that operate on a cash accounting basis often struggle to provide this information.
- Budget Planning Challenges: With cash accounting, it is difficult to link costs incurred to revenue generated since revenue recognition is delayed until cash is received. This delay can make it challenging to forecast and budget for cash flows in future periods. It may not accurately reflect the real revenue and expenses that will occur in that period, leading to missed opportunities, cash flow problems, and inaccurate financial reporting.
Cash vs Accrual Accounting: Pros and Cons of Accrual Basis
If the debate between cash basis vs accrual basis accounting were a popularity contest, accrual accounting would win by a landslide. In this section, we will delve into the pros and cons of the accrual accounting method.
Pros of Accrual Accounting:
- More Accurate Picture of the Company: The accrual accounting method aims to provide a more accurate overall picture of a business’s state. Accrual accounting ensures that all of the company’s activity is captured in the month it happens instead of when it collects or pays out money in future periods.
- Improved Forecasting and Budgeting: By using the accrual accounting method, you get a more realistic picture of your profitability. For instance, if a year has passed and Brightstar has paid you another $500,000, but you have transitioned the company to accrual basis accounting, you will prorate the revenue over the 12-month contract. This total in a given month now provides a more accurate reflection of profit/loss and allows for better budgeting and forecasting discussions.
- Attractiveness to Investors: Investors prefer businesses that perform accounting on an accrual basis. Not only does it communicate a level of professionalism, but it also helps them better judge your business. Since you’re already accounting for accrued revenue and expenses, you and your investors can see how profitable your business will be over the long term. Accrual accounting allows you to provide a glimpse of the future state of the business after the accrued expenses are paid and accrued income is received.
- Compliance with GAAP and IRS: Companies with annual gross receipts of more than $25 million must use the accrual accounting method. GAAP-compliant companies that are not publicly traded but have outside investors may also have this requirement.
The cons of accrual accounting
- Complexity: Accrual accounting is often more time-consuming and complex than cash accounting. Companies are required to keep more detailed records, which involve more calculations and adjustments every month. There are also many more regulations governing accrual accounting, which means companies wanting to utilize accrual-based accounting will see an increase in administrative work and may have to increase staff numbers to keep abreast of all the extra tasks.
- Judgments Must be Made: Accrual accounting may sometimes require you to make judgments and estimates, which can be subjective and open to interpretation. This can make financial reporting more challenging, particularly if your business has complex operations or revenue streams.
- Cash Flow Issues: While accrual accounting provides a more accurate picture of a business’s financial health, it can create a disconnect between a business and the cash actually sitting in the bank account. This can make it difficult to manage cash flow, particularly for businesses with long payment terms or a high level of accounts receivable. It also means that even if a business migrates from a cash accounting to an accrual accounting system, the owners will still have to allocate headcount to monitor the company’s cash flow.
- Tax Issues: Companies operating an accrual accounting system will be taxed on the revenue they report in a given year, whether they have received payment from their customers. This means that even if you deliver goods to Brightstar in December but don’t receive payment until January of the following year, you must recognize the revenue in December according to the accrual accounting method. This could lead to an increase in your taxable income for the year and a higher tax liability.
Cash vs Accrual Accounting – Which Should I Choose?
When clients come to indinero with inquiries about cash accounting versus accrual accounting, we always suggest using accrual accounting. We are of the firm belief that accrual accounting offers a more comprehensive financial overview, providing you with the necessary information to make sound business decisions with your funds. As your business expands, switching to accrual accounting is the right choice to make.
How To Switch From Cash To Accrual Accounting?
While accrual accounting is the preferred method, migrating to an accrual basis system cannot be done overnight. It requires careful planning, a methodical transition process, and complete buy-in from all affected teams.
If you believe it’s time for your company to move on from cash basis accounting, partnering with an experienced accounting service provider such as indinero could prove vital to your transition. There are several ways that inDinero can support the process:
Analyze your existing accounting system
Our team can examine your current system and highlight areas that may cause issues during the changeover. This could include reviewing your chart of accounts or locating gaps in your financial data.
Developing an implementation plan
We can work with you to develop a plan tailored to your specific circumstances, budget, and timeline. Our expert guidance can help you identify the upgrades you need to make to your systems, help you to re-write your existing accounting policies, and develop a training program for your staff.
Providing support throughout the process
As an experienced accounting services provider, we can support you at every stage as you transition to the accrual accounting method. This can range from overseeing the transition on your behalf to helping you, after the switch over, with areas such as forecasting and budgeting.
Still Have Questions Around Cash Basis vs Accrual Basis?
If you have any questions about cash vs accrual accounting, we would be happy to discuss them with you. Guidance on this important decision is just one small part of the financial services we can offer your business.
At indinero, we pride ourselves on being a leading nationwide provider of accounting services, tax preparation, and budget planning. Contact indinero today and see how our expert team can support you and your business.
Discover more from reviewer4you.com
Subscribe to get the latest posts to your email.
