The Difference Between Cash-basis and Accrual Basis of Accounting
An essential decision you will make for your organization/business is selecting the most suitable accounting method for your business because this will eventually direct everything from tax filings to financial reporting.
Nonetheless, the motive for selecting a given accounting choice varies based on the business needs and size. Picking the right accounting method calls for some consideration, especially because the IRS expects you to choose one system and stick with it.
Cash Basis Accounting
This is the system used by most individuals for their personal finances, such as keeping record of the balance in their accounts. Cash basis accounting records expenses and income at the time that the transaction takes place.
With a personal account, we can liken deposits to revenue and checks to expenses, so when deposits are added or checks are deducted, they are written. Cash-basis accounting method works in a similar manner for businesses.
Expenses are recorded when paid and sales are recorded when imbursement is received all without concern to when expenses are incurred or services are delivered. In Simple terms, cash basis accounting is dependent on when cash changes hands.
Cash accounting identifies income when you receive payment for a transaction, and expenditures when you pay for a purchase. It is easy to define when a deal took place – you just look at when the fund left or entered your bank account.
Most business owners and entrepreneurs prefer cash accounting because the need to track account payable or account receivable is absent. But while cash accounting provides precise image of how much cash you have right now, it does not accurately reflect your business’s financial health in the long run. And that can result to having an exaggerated income or inconspicuous expenses.
Here is an example:
Dan performed only three landscaping jobs and his sales in the month of January were bad. That same month, he received $6,000 in past due payments for jobs he performed in October. Using cash basis accounting method, Dan’s books would show his business did well in January meanwhile it did not.
Accrual Basis Accounting
Accrual accounting method is more complex than cash accounting because invoices need to be tracked – not just your bank balance. Accrual accounting identifies expenses when you incur them and income when you deliver a product or service.
Accrual basis accounting is projected to match up income and outgoings as they are delivered or incurred, without consideration to when payment is received or issued.
Accrual accounting gives you a realistic image of your business’s financial state because it best matches the timing between outgoings and incomes.
Here is an example:
Your customer places an order for a product worth $3,000, and you ship the goods, letting the customer 30 days to pay for the product. You would record the trade in the current time, with the offsetting entry to the accounts receivable section of the balance sheet. When you finally receive payment for the product, you would not need to record sales; rather, the records would be to cash and accounts receivable.
What Is The Key Difference Between Cash And Accrual Accounting Method?
The main difference between cash basis and accrual accounting method is the timing of when the expenditure and income are logged and acknowledged. Accrual basis accounting focuses primarily on foreseen expenses and income; on the other hand, cash basis accounting method is more instant in identifying and acknowledging revenue and expenses.
Cash basis: The deal and income are tracked and recorded when cash is received from the client. Expenses are recorded when cash is paid to suppliers and employees.
Accrual Basis: The revenue and transaction are recorded when income are earned and expenses are spent/disbursed.
The Pros and Cons of Each Method
The cash basis method is actually the simplest and most familiar method to the majority of business people, especially small business owners. Plus, it offers you the best view of how much cash you have at hand for operating your business. Nonetheless, you will always get a biased picture of your business’s financial health because your income and expenses as profit and loss are often documented in different periods.
For example, assuming you spend $1,300 on July 10 to purchase products to fill a client’s order. Your customer picks up his order on August 2 and pays you $2,800. In the likely event that you had no financial transactions for the month, your income report would show a loss of $1,300 in July and a profit of $2,800 in August.
A better way of matching your income and expenses to applicable periods is by using the accrual method of accounting. This method gives you a clearer valuation of your actual profit or loss. Though, the accrual method tends to give you an unclear view of how much operating cash you truly have accessible, so you might need to review your cash flow record now and then to get a clearer image of your available finances. The accrual method is also more complex and consumes a lot of time to execute, sometimes the support of professional accountants is needed to execute and analyze data.
Choosing the Best Method for Your Business
In every case, it’s best to consult your accountant before selecting an accounting method. Make sure your books are up to date. In the meantime, ensuring you don’t scramble when time for taxes come.
If you’re in doubt as to how to get your books in order and keep them that way, GritForce’s experienced team of bookkeepers and accountants can help.
Reach out to us for more information.