Cash Basis vs. Accrual Basis of Accounting
As a business owner when you first began working with an accountant, they most likely asked you: Do you use cash or accrual basis? If that question had you scratching your head, you’re in the right place because we are going to talk about this not so exciting but important topic. Specifically, we'll be looking at the difference between cash basis and accrual basis accounting, examples under each method and which method is best for your business.
Cash Basis of Accounting
Cash basis accounting is a method of accounting that “follows the cash” meaning a transaction is recorded when cash is exchanged. In other words, revenue is recorded and recognized when the cash is received, and expenses are recorded and recognized when the cash is paid. For example, if a small business sells a product for $1,000, and the customer pays in cash, the business would recognize $1,000 in revenue immediately. Similarly, if the business pays $500 for rent in cash, it would record the expense of $500 at the time the payment is made and not necessarily in the month the rent was actually for. Let’s break this down a little further, let’s say in January you pay your February rent, under cash basis you would record this expense with a January date even though it was actually for February.
Cash basis accounting is best for businesses that have a low volume of transactions and do not need to track inventory or have long-term assets nor have accounts receivables and payables. This method is simpler and easier to use than accrual accounting, and it provides a more straightforward picture of a business's cash flow. Businesses that operate on a cash basis are small businesses, sole proprietorships, and individual freelancers that do not need to track inventory or have long-term assets. It's also worth noting that, Cash basis accounting is also a good option for tax purposes as it more closely aligns with the way in which income and expenses are reported for tax purposes.
Accrual Basis of Accounting
Now let’s discuss the accrual basis of accounting. Accrual basis accounting is a method of accounting that records transactions when they occur, regardless of whether cash has been exchanged. In other words, revenue is recognized when it is earned, and expenses are recognized when they are incurred. For example, if a small business sells a product for $1,000 but the customer does not pay until next month, the business would recognize the $1,000 in revenue immediately (and record a receivable), even though it has not received the cash yet. Similarly, if the business receives an invoice for $500 for rent in April but does not pay it until May, it would record the expense of $500 in April when the expense was incurred, not in May when the payment was made.
Accrual basis accounting is best for businesses that have a high volume of transactions, need to track inventory, have long-term assets as well as accounts receivables and payables. This method provides a more accurate picture of a business's financial performance and health, and it is required by Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS). Businesses that operate on an accrual basis are large corporations, public companies, and retail businesses that sell products, as they need to track inventory and have long-term assets. Also, small businesses with goals of going bigger and potentially partnering with investors will want to adopt the accrual basis of accounting as converting from cash basis to accrual basis can be a time consuming and tedious project and therefore implementing it from the start can save a business time, money and a headache.
It's also worth noting that accrual basis accounting can be more complex and time-consuming to use, but it provides more accurate, detailed financial statements that can be used for decision-making and compliance as well as provides a more accurate prediction of future cash flow.
Cash vs. Accrual Basis Example
On the left we have an example of transactions within a Company and the breakdown of how each transaction impacts the income statement under each method.
Notice how under the accrual method, we recorded the income and expenses in the month the event took place and services were rendered to the customers and the venue was actually used. Whereas under the cash basis method, we simply recorded each of these transactions based on when the cash was paid out or received.
Ultimately, the decision of which accounting method to use is up to you and your accountant. But it's important to understand the difference between cash basis and accrual basis accounting so that you can make an informed choice. Whether you go with cash basis or accrual basis, keeping track of your finances is crucial for the success of your small business.
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