Cash Basis vs. Accrual Basis: Which Method is Right for Your Small Business?
As a small business owner, you’re going to have many choices to make. Some will have more obvious answers while others will fall into the “gray” category and may require some research and thought. Knowing the difference between cash basis vs. accrual basis method of accounting will be an important tool in order to position your company for future success.
Each method has different effects on cash flow, how much in taxes you pay, and your bottom line. That being said, you should spend some time determining what type of accounting method to implement for your small business. This, of course, depends on the nature of your business and how you want to account for liabilities and assets on your balance sheet.
With that in mind, it is important to look at the differences between cash basis vs. accrual basis accounting in order to determine which is best for your particular small business. This is important because your tax liability will vary with each method.
Cash Basis Accounting
The cash basis method of accounting is based on when the exchange of cash takes place. So, you will recognize revenue when the cash is received or record an expense when once you pay the bill. Therefore, there isn’t a need for accounts receivable or accounts payable when using the cash basis method. Since no transactions are recorded on the books unless you spend or receive money, this is the simplest method to utilize when accounting for the activity that takes place within your small business.
This method of accounting is commonly used by small businesses primarily because it is relatively simple to keep up with and maintain.
Examples of the types of small businesses that use cash basis of accounting are freelancers or service based businesses.
With cash basis accounting, they key is to record the transaction when the exchange of cash happens. Meaning you spend money to pay bills or receive money from a client for an item you sold or services you provided. This should be fairly simple because money either comes into the bank via a deposit, or it goes out of the bank by way of a withdrawal.
Perhaps the reason this is the most common method and easiest to understand is that this is how most households operate their finances. A small business using the cash basis method of accounting is able to keep track of how much cash is actually on hand at any moment during the month. The money in the bank reflects the resources that you have available for use. More importantly, you won’t pay taxes until the money is in the bank when using this method of accounting.
Accrual Basis Accounting
Using an accrual based accounting method rather than vs. cash basis accounting doesn’t change how your financials look but rather how you will interpret them. The key differences are not IF you record the business transaction but rather WHEN.
Under this method, revenues are recorded the moment that they are “earned” (when services are rendered) and expenses are recorded as they are incurred. Meaning no money has actually been received or spent as of the date the sale or purchase took place. Accrual basis is more commonly used by businesses that larger rather than the cash basis method. This is simply because some businesses are required to use the accrual basis in order to comply with the generally accepted accounting principles known as GAAP (learn more here).
One benefit of accrual basis method of accounting is that allows for a better analysis of your business’ financials. You can set more long-term financial goals since you have a better grasp on your income income earned and expenses incurred over a period of time.
Examples of the types of small businesses that use the accrual method of accounting are businesses that sell a product or have inventory.
A downside to the accrual basis accounting is that it doesn’t show you true cash flow. It may look like your profits are increasing when in actuality your bank account is nearly overdrawn. Because of this, it is critical that a business using the accrual method constantly monitor cash flow in order to ensure that monthly obligations can be met.
Cash Flow Effects
It is important to understand how both the cash basis vs. accrual basis methods of accounting can effect the business’ financials. To understand the direct effect on the bottom line, let’s consider the following example:
In the month of July, you invoice a client for $3,000 of consulting work, the client pays you $1,000 in cash towards that invoice and you pay $100 towards the May’s Supplier bill.
Now, let’s pretend these were the only three transactions that took place in the month.
Under the cash basis of accounting, your Income Statement would show a profit of $900 for the month. Only the exchange of cash is recorded on the books.
July Income Statement (Cash Basis)
Revenue $1,000 (What you actually received)
Expenses -$100 (What you actually Spent)
Under the accrual basis accounting, your Income Statement would show a profit of $3,000 for the month. Only the invoice sent to the client in July would be recorded as income. The May supplier invoice was recorded on the May Income Statement.
July Income Statement (Accrual Basis)
Tax Implications of the Different Accounting Methods
The example above can also be used to illustrate the effect that the accounting method you choose has on the tax situation for a small business.
Imagine that the same scenario described plays out in November and December of any given year. As we discussed before, one of the key differences between the cash and accrual methods of accounting is related to the tax year that both income and expenses are actually recorded in.
If you were to use cash basis accounting, you will record the income the moment that it is received. This is not the case with the accrual system, as the income is recorded when you actually earn it, even if you do not yet have the money in your pocket.
Given the previous example, the cash basis of accounting would have you pay taxes on the profit of $900 vs the accrual method above would have you pay taxes on $3,000. The biggest downside to the accrual method is you may have to pay taxes on money you haven’t received.
You may be thinking—Do I pay less in taxes on the cash basis than the accrual basis? Despite what the example shows, you will pay taxes on the same profit in either method, the only difference is really when you pay the taxes.
In the example above, the accrual basis will pay taxes on more profit this year and less next year. Whereas the cash basis would pay less this year and more next year.
Why would anyone choose accrual over cash method? Typically the reason is the IRS requires it. If you are selling products, then the accrual method may be required depending on the amount of revenue you have.
Be sure to consider your business model and how you operate when determining which method of accounting you feel is best for your small business. In the end, it may be wise to have an accountant handle matters related to your taxes just to make sure you’re in compliance with rules and regulations of the IRS. This way everyone is happy in the end.
Have more questions on Cash Basis vs. Accrual Basis methods of accounting or other topics related to small businesses? Reach out to us via our contact page and we will be happy to talk to you further.