The difference between cash and accrual accounting is important to understand, whether you plan to handle your own financial statements, or hire an outside professional. The difference lies in the timing of when sales and purchases are recorded in your accounts. Read on to understand the implications of using each accounting method.
Cash Based Accounting
The cash basis of accounting recognizes revenues when cash is received, and expenses when they are paid. This method does not recognize accounts receivable or accounts payable.
Many small businesses opt to use the cash basis of accounting because it is simple to maintain. It’s easy to determine when a transaction has occurred (the money is in the bank or out of the bank) and there is no need to track receivables or payables.
The cash method is also beneficial in terms of tracking how much cash the business actually has at any given time; you can look at your bank balance and understand the exact resources at your disposal.
Also, since transactions aren’t recorded until the cash is received or paid, the business’s income isn’t taxed until it’s in the bank.
Accrual Based Accounting
Under the accrual basis, revenues and expenses are recorded when they are earned, regardless of when the money is actually received or paid. This method is more commonly used than the cash method.
The upside is that the accrual basis gives a more realistic idea of income and expenses during a period of time, therefore providing a long-term picture of the business that cash accounting can’t provide.
The downside is that accrual accounting doesn’t provide any awareness of cash flow; a business can appear to be very profitable while in reality it has empty bank accounts. Accrual based accounting without careful monitoring of cash flow can have potentially devastating consequences.
The Effects of Cash and Accrual Accounting
Understanding the difference between cash and accrual accounting is important, but it’s also necessary to put this into context by looking at the direct effects of each method.
Let’s look at an example of how cash and accrual accounting affect the bottom line differently.
Imagine you perform the following transactions in a month of business:
- Sent out an invoice for $5,000 for a web design project completed this month
- Received a bill for $1,000 in developer fees for work done this month
- Paid $75 in fees for a bill you received last month
- Received $1,000 from a client for a project that was invoiced last month
The Effect on Cash Flow
Using the cash basis method, the profit for this month would be $925 ($1,000 in income minus $75 in fees).
Using the accrual method, the profit for this month would be $4,000 ($5,000 in income minus $1,000 in developer fees).
This example displays how the appearance of income stream and cash flow can be affected by the accounting process that is used.
The Effect on Taxes
Now imagine that the above example took place between November and December of 2013. One of of the differences between cash and accrual accounting is that they affect which tax year income and expenses are recorded in.
Using cash basis accounting, income is recorded when you receive it, whereas with the accrual method, income is recorded when you earn it.
Following the above example, using accrual based accounting, if you invoice a client for $5,000 in December of 2013, you would record that transaction as a part of your 2013 income (and thus pay taxes on it), even if you end up receiving the payment in January of 2014.
How to Choose an Accounting Method for Your Business
You’ll need to choose an accounting method when you file your first tax return, and then use it consistently on all subsequent returns. A trusted CPA can help you determine which accounting method is best for your business.
Be aware that some businesses are required to use the accrual method, so the specifics of your business may dictate which you choose.
To change accounting methods, you need to file Form 3115 to get approval from the IRS.