A crucial component of any business is proper accounting practices. Without this, business owners wouldn’t be able to run their companies effectively. After all, accounting helps track income and expenses, ensures statutory compliance, and offers quantitative financial data for investors, management, and the government to aid their business decisions.
There are two main methods to consider: cash and accrual accounting. Each method has its key differences, advantages, and disadvantages. The right one for your business depends on your goals and your business structure.
Keep reading to learn the difference between cash and accrual accounting and which is the best fit for your company.
The Differences Between Cash and Accrual Accounting
The expression “timing is everything” captures the most significant difference between cash and accrual accounting. Both methods have their pros and cons, with very distinct differences that come down to timing.
Accrual accounting is a method that records revenue when a sales transaction occurs. It also records expenses when a transaction for purchasing goods/services happens. In other words, accrual accounting records revenues and expenses before payments are received or issued.
On the other hand, a cash basis records revenue and expenses when the actual payments are received and disbursed. It doesn’t account for them when the transactions that create them occur but instead records them after they have gone through.
Cash Basis vs. Accrual Accounting Example
Let’s say you’re the owner of a car dealership. If you sell a vehicle worth $10,000 under the cash method, the amount won’t be recorded in the books until the buyer hands you the money.
Under the accrual method, the $10,000 will be recorded as revenue the day your salesperson made the sale, even if you receive the money days later.
The same goes for expenses. Let’s say your car dealership receives an electric bill for $800. Under the cash basis method, you won’t record this expense until your company pays the bill. Under the accrual method, the $800 will be recorded as an expense the day your company receives the bill.
Cash Flow and Tax Liabilities
Either method significantly impacts a company’s cash flow and tax liabilities. It also impacts the policies and processes that an organization must adopt.
Here are a few examples:
- Businesses that use the cash method won’t have accounts receivable ledgers. They’ll need processes to stay on top of outstanding customer accounts.
- Companies that use the cash method will deal mainly with cash transactions. They’ll need safeguards over receipts and disbursements to avoid loss or theft.
- Businesses that use the accrual method have procedures to reconcile bank accounts and keep track of short-term cash flow.
- Start-up businesses that use cash accounting for its simplicity often need to change their accounting practices in later stages when they start to invest in long-term assets.
The Advantages of Each Method
This next section will help you better understand and determine the best method for your company. Let’s look at the advantages of each.
This method offers several advantages for small businesses. We’ll go more into depth on the types of businesses best suited for this accountant method a little later.
Here’s what you can expect from this accounting method:
- Easy to use. This method is more straightforward than accrual accounting. It’s suited for sole proprietors and small businesses that can handle accounting with pen and paper.
- Tax advantages. By effectively timing your transactions, you’ll be able to take advantage of tax breaks. You can legally lower your tax liabilities by speeding up expenses or slowing down revenues.
- Better cash projections. The entire accounting system revolves around cash flow. This system offers a clear picture of transactions. Complex accrual-based systems often lose this clearness.
Further, this method does not need to account for customer sales made on credit. Likewise, no bookkeeping is required for purchases from vendors on credit until the company pays for them.
Accrual accounting offers undeniable benefits for businesses of all sizes. Here’s what you can expect:
- Accurate financial reporting. Businesses can easily track all transactions using an accounts payable and receivable system. The accounting system accurately represents a company’s revenue and expenses.
- GAAP compliance. This method is accepted by the Generally Accepted Accounting Principles (GAAP). This compliance is crucial for business owners looking to borrow funds from investors or banks.
- Improves planning and reporting. With accurate financial reports, companies can analyze, plan, and strategize. It’s easier to plan when financial reports match operating activities.
The Disadvantages of Each Method
Let’s explore the disadvantages of these accounting methods:
Cash-based methods have some clear disadvantages that make them unsuitable for certain companies. Here’s what you need to know:
- Possibility of inaccurate reporting. The main disadvantage of this method is that financial results may look distorted in any given period. Business owners can show a profit by not paying bills during a period, even if they’ve incurred those expenses. The gap makes it easy to mislead the system.
- Inventory management. With this method, inventory is treated as an expense. It becomes an asset until sold for cash. Filing inventory as an expense can lead to skewed figures. For this reason, the IRS restricts companies that maintain inventories from using this method.
- Not GAAP compliant. GAAP doesn’t accept cash accounting. Any resulting financial statements are considered insufficient by most lenders. Likewise, they are prohibited from publicly traded companies.
Just like the cash method, the accrual method also has its disadvantages. These include:
- Steep learning curve. Unlike cash basis, accrual-based methods require an effort to learn and comprehend. Some businesses may lack the skills or resources to do this if they don’t have professional accountants on staff.
- Cash flow uncertainties. Accrual accounting may hide short-term cash flow issues in a business that looks profitable on paper. Planning, budgeting, or strategizing uncertainty may arise when indicating profits before they materialize.
- Requires additional bookkeeping. Instead of seeing cash come in and out of your company, businesses need to monitor receivables, prepaid expenses, accounts payable, and other accrued liabilities to manage cash flow.
Choosing Between Cash and Accrual Accounting
Every business is different and will benefit differently from cash or accrual accounting. For companies with investors or lenders, there is only one choice—accrual accounting. They must comply with GAAP and use this method for financial reporting and tax purposes.
On the other hand, some businesses do have a choice. Companies with less than $25 million in gross receipts can choose either method. However, start-up businesses that use cash accounting for its simplicity often need to change their accounting practices in later stages when they start to invest in long-term assets.
A cash basis may be suitable for your business if you rely heavily on cash payments for revenue and expenses. However, companies that offer credit to customers or use credit with vendors will find that accrual accounting offers a better picture of financial health.
With this information in mind, you’re one step closer to deciding the proper accounting method for your business. While the cash basis method is more straightforward, accrual accounting is more accurate.
Still unsure of which accounting method is right for your business? Get in touch with MI Tax CPA to learn more.