There are two ways of accounting – cash basis accounting and accrual basis. The main difference between them lies in the timing of when revenue and expenses are recognized.
Cash Basis Accounting
The cash basis method is the simplest method to use because no complex accounting transactions are required. When you receive the cash for a service or product, you realize the income. When you buy something, and cash is exchanged, it is realized as an expense.
Take rent, for example. Let’s say you pay rent in December for January. Using cash basis accounting, you would deduct the expense in December when payment is made.
The same purchase using the accrual method is treated differently. The month in which you record the transaction might not be the accounting period in which the expense occurs. You need to make an adjusting entry.
Initially record prepaid rent as an asset, it becomes an expense in January when used. In that case, you would use a journal entry in your accounting records in January to expense the rent in the correct month.
Advantages of Cash Basis Accounting
- Easy to Understand: Cash basis accounting tends to be easier to understand than other accounting methods.
- Shows Cash Flow: The cash method most resembles a cash flow statement. It provides an accurate picture of how much cash your small business has on-hand.
- May Reduce Taxes: If you file your taxes on a cash basis you are postponing the tax due until the cash is received. You may not change the way file taxes from year to year to your advantage. Check with your accountant to determine if cash or accrual is appropriate for you.
Disadvantages of Cash Basis Accounting
- Short-Term Indicator: The cash basis may offer a misleading picture of your profitability. No attempt is made to match an expense with the revenue it generates. The income statement and balance sheet may not be a good picture of recent business activity and present business conditions.
- Restrictions: According to the IRS, you cannot use the cash method if your business maintains inventory, is a corporation, or has gross receipts in excess of five million dollars per year.
Accrual Basis Accounting
With accrual basis accounting, transactions are accounted for when the transaction is earned, regardless of when cash is paid or received. Income is recorded when the sale occurs, and expenses are recorded when goods or services are received.
Advantages of Accrual Basis Accounting
- Profitability Margins: Since you are matching revenues and related expenses within applicable periods you can better analyze profitability.
- Consistency: The consistency of recording revenues and expenses allows for easier budgeting and forecasting
- Financing: Most banks and investors request financial statements using the accrual basis of accounting
- Better Picture: The accrual method provides a better picture of the financial results of the business
Disadvantages of Accrual Basis Accounting
- Complicated: The accrual basis of accounting is slightly more complicated from an accounting and tax preparation standpoint.
- Deception: Some businesses have misused the method to hide weaknesses and mistakes within their financial reports. Simply put, it can be used to hide fraud.
Not sure what method your small business should use? If the recipient of your financial information is limited to internal users and there are a minimal number of transactions, the cash method may be appropriate. If your business is seeking outside investors, the accrual method is the most desirable.
Use Both!
QuickBooks makes it easy to toggle between accrual and cash basis. Many small businesses use both. You can monitor the success of your business using the accrual method but file taxes on a cash basis.
Interested in learning more? Contact us at 216-333-1303.
