What is the difference between accrual and cash accounting? Business owners should understand the answer to this question, especially as a small enterprise begins to expand into a larger company. If you don’t already do your own bookkeeping, you may want to hire someone to keep track of your business’s financial transactions. Doing so allows you to claim tax deductions when you file your business’s tax return at the end of the year.
The Internal Revenue Service requires businesses to have a consistent method of keeping track of expenses and revenue. Review this guide to familiarize yourself with the similarities and differences between cash and accrual accounting so you can determine which method will work best for your business.
Differences Between Cash and Accrual Accounting
When reviewing what is the difference between accrual and cash accounting, these are the key points you should understand.
Timing of Revenue and Expenses
Timing of revenue and expenses recording represents the primary difference between cash and accrual accounting. Cash accounting recognizes revenue and expenses immediately when cash changes hands while accrual accounting focuses on the future by recording sales and purchases when they occur. By contrast, cash accounting does not recognize these items until the money actually enters or leaves the business bank account.
Cash accounting tends to be easier than accrual accounting, so this method is popular for individuals and small businesses. Accrual accounting can be complex because of the addition of prepaid expenses and unearned revenue. This complexity means that companies need to dedicate more resources to accounting than they would if using a cash method.
However, the IRS requires businesses that earn more than $25 million in sales annually to use the accrual accounting method. Most accountants also recommend accrual accounting for businesses that keep an inventory of products on hand.
Because of its simplicity, cash accounting can create recordkeeping challenges. Because you have not documented current accounts receivable and accounts payable, it can be difficult to keep track of money your clients owe and bills you have to pay.
Because accrual-based accounting documents accounts receivable and payable, it more accurately portrays the financial health of the business than a cash accounting system does. For this reason, more companies use accrual accounting than cash accounting, particularly companies that trade on public stock exchanges.
If a company has significant debt but plenty of cash, cash accounting books might provide an overly rosy picture of the business’s financial health. On the other hand, a company that has a short-term cash shortage could appear profitable in the long-term with the accrual accounting method.
Cash Flow Awareness
Many business owners appreciate cash accounting because they can see at a glance when money changes hands. They can also easily track the business’s current cash flow and have a constant handle on available resources.
Businesses that use cash accounting will not pay tax on accounts receivable, only on funds actually received. For example, if you sell your customer a product for $500 in October and they pay in January, the IRS would tax your revenue in the new tax year. With the accrual accounting method, businesses pay taxes on money that they have not yet received.
Adherence to Financial Standards
As mentioned above, businesses with sales of more than $25 million a year must follow the accrual method of accounting. That’s because cash-based accounting does not follow the Generally Accepted Accounting Principles, which establish the best practices companies must use when tracking income and expenses. Businesses that earn or expect to earn close to the $25 million threshold should adopt accrual accounting to comply with GAAP.
Even smaller businesses may want to use accrual accounting as soon as they start bookkeeping so that they don’t have to change to a new method as the company grows. If your company does decide to switch from cash to accrual accounting, you must do so at the end of the tax year and not in the middle of the year.
Best Practices for Bookkeeping
You’re an entrepreneur but you don’t have much experience with accounting. Sound familiar? Once you decide between cash and accrual accounting, follow these tips to keep your books in order and prevent financial issues that can impact the profitability of your business.
Separate Personal and Business Finances
Even if you run a sole proprietorship, mixing personal and business funds can cause serious issues. This practice makes it more difficult to file taxes, impacts the cash flow of your company, and puts you at risk for personal liability for business debts. If you have not already done so, open separate bank accounts and credit cards for your business.
Rely on Financial Software
Gone are the days where “the books” are actually books. Instead of a paper ledger, use financial software to elegantly manage and organize your business finances. You should choose a program that fits your current needs and can grow with your business’s projected expansion over the coming months and years.
Keep Accounts Payable and Receivable Under Control
Establish and maintain a system for keeping track of accounts receivable. Send out regular invoice reminders to your clients and make sure your contract provides for a late payment fee. Past-due invoices can be a serious drain on your company’s cash flow.
By the same token, make sure you pay your business’s bills on time and in full. Failure to do so can result in costly late fees and harm your company’s ability to qualify for loans and credit.
Review the Records
Set a standing appointment to take a look at your business’s books each month. Look for anything that seems out of the ordinary, such as a major expense or huge windfall you didn’t know about already. Even if you hire a professional to do your books, you should still have a handle on the cash flowing in and out of your company.
MI Tax CPA provides full-service tax and accounting services for clients throughout Michigan. We specialize in serving the small businesses and cannabis businesses that make up our local communities and meeting their accounting needs, from comprehensive accounting to annual tax filings. If you need help with bookkeeping for your business, complete our online form or call today to schedule a consultation.