For accountants, the concept of cash vs. accrual is straight forward. But small business owners often don’t understand it or how it affects their business. Business owners will typically leave the decision to their accountants on whether their business should be on a cash basis or accrual. Still, owners need to understand the difference, so they know how transactions affect their financial statements. So, let’s look at these two accounting methods and break down some of the differences
Cash accounting is an accounting method that recognizes income when cash is received and expenses when cash is paid out. The cash method is a very straight forward and simple measure of recording income and expenses. If you’re thinking, “that’s the same way I manage my personal finances,” you’d be right.
So how does this work in a business? It’s as simple as it sounds. Income is recorded every time you receive payments from customers for the goods or services you have sold to them. On the other hand, expenses are recorded every time money comes out of your bank account to pay for the goods or services you need to run your business. When using the cash basis, your income statement is a simple calculation of cash less expenses equals income.
CASH RECEIVED – CASH PAID OUT = INCOME
What are the advantages and disadvantages of using the cash method?
One of the advantages of using the cash method is that it’s simple to use and understand. Managing finances in a small business can be difficult and frustrating, so having a simple accounting method makes this a bit less trying. Also, many small business owners like that they pay taxes based on the cash amount that has come into the business. This creates a situation where you can plan for payment of taxes without any surprises
On the downside, the cash method is less accurate regarding understanding how your business is performing. An excellent example of this can be seen in comparing transactions for a month. If you billed customers for $15,000 and received $10,000 in payments, using the cash method, you’ve made $10,000. But your business generated $15,000 in revenue, which can be misleading when trying to understand your business’s performance.
The accrual method of accounting recognizes income when you create an invoice to your customer and expenses when you receive bills from your vendors. The accrual method is a bit more complicated but provides better insights into how your company performs than the cash method.
So how does the accrual method work in a business? Since the accrual method recognizes income and expenses when they are “accrued,” income is generated when you create an invoice for your customer. On the other hand, expenses are recognized when you receive a bill from a vendor. However, the accrual method gets a bit more complicated. Let’s use an example of an asset that you purchased and have decided to depreciate. Depreciation is used to show the declining value of an asset over the life of that asset. This gives a far more accurate picture of the assets and liabilities of a company. For our example, let’s say we purchased a piece of equipment for $12,000 and paid cash. Let’s also assume that the life of the asset is five years or 60 months, and we use the straight-line depreciation method (this is a method that divides the cost of the asset by the life of the asset). In our example, the depreciation calculation would be:
$12,000 ÷ 60 + $200
Using the accrual method, you would set up an asset call equipment in your balance sheet for $12,000, a liability called accumulated depreciation, and an expense account called depreciation. Each month, you record the depreciation by debiting the depreciation expense account and crediting the accumulated depreciation account. The effect of this is to have an asset on your balance sheet of $12,000, that’s value is reduced monthly by $200 over the course of 5 years.
As seen in our equipment example, the accrual method can get complicated. For small businesses, the accrual method is complex and hard to understand. In addition, from a tax perspective, there can be some challenges. In the example we used earlier of a customer being billed for $15,000, but the business received $10,000, the business must recognize the $15,000 as income in the accrual method. This can create a situation where businesses are taxed for revenue, but they have not received the cash, making it hard to cover their tax bill.
However, one of the significant advantages of accrual accounting is that it illustrates a better representation of your business performance, especially if you have fixed assets or inventory. In our example, the cash method would have recorded $12,000 of expenses when the asset was purchased. But using the accrual method, we account for the expense of the asset and its value over the asset’s expected life. This provides a more accurate picture of the assets, expenses, and ultimately the business’s equity over time.
This is a question that you should direct towards your CPA. There are cases where a business is required to use accrual accounting. For startups and many small businesses, cash accounting is often preferred. That said, several businesses keep their books on the accrual method and file a tax return on the cash basis of accounting. This example gives the business the best of both worlds. They have better insights into their actual performance and provides them with a lower tax liability.
Whether your business utilizes a cash or accrual method of accounting, accurate and up to date recording of income and expenses deliver the most precise picture of your business’s health. Understanding expenses and costs and tracking them in an accounting program, such as an online bookkeeping service, ensures you view a real-time picture of your financial position.
Why not hire Carly, and join our growing group of business owners who trust Carly with their cash or accrual bookkeeping?