The Difference Between Cash-Basis and Accrual-Basis Accounting For Your Business
Maintaining accurate and organized accounting records are one of the best things you can do to ensure your business is successful. In this article, we will focus on the two ways that you can organize your accounting records - either “accrual-basis” or “cash-basis”. We will look at what they are, which type of business is likely to use which method, and the advantages and disadvantages of both.
Before we look at the two methods, let’s first understand why there are two methods and why you would need to choose just one. They key difference between the two methods is how you record income and expenses. The way you record any income and expense transaction using one method would be different than the other method.
The reason why you would choose one method is so that your accounting records stay consistent. It would be very confusing when reading your accounting statements if you switched between the methods. It is like reading a weather forecast for the next ten days where the first four day’s temperatures are reported in Fahrenheit and the last six days are reported in Celsius. Also, once you choose one method, the IRS prefers you stick to that method. In fact, once you choose one method and later change to another method you must get the approval of the IRS.
The Accrual-Basis method of accounting states that all income and expense transactions are recorded on the books when they actually occur regardless of when you receive payment for the sale or when you paid for the expense purchase. If you purchase supplies in January but do not pay for the supplies until February then you would show an expense for the supplies in January. You would then record an entry to an account, in this case Accounts Payable, to reflect that you still owe for the supplies.
Here are two examples:
A pool installation business makes a $10,000 sale to a customer in April. However, the customer is setup to pay over time for the pool. This company would record an income to their books in the month of April for $10,000 even though the company did not receive payment in the month of April.
The same company purchases $5,000 worth of supplies in May from a vendor but the company does not pay for the supplies until August. This company would record an expense to their books in the month of May for $5,000 even though they did not pay for the supplies in May.
The Cash-Basis method of accounting states that all income and expense transactions are recorded on the books when you actually receive in cash or pay out cash for an income or expense, regardless of when the sale or purchase took place. If you purchase supplies in January but do not pay for the supplies until February then you would show an expense for those supplies in February.
Here are two examples:
A plumbing installation business makes an $8,000 sale to a customer in October; however, the customer does not pay until November. In this instance, using the cash-basis method, the company would record a sale for $8,000 in the month that the customer paid, which would be November.
The same company purchases $3,000 worth of supplies in November from a vendor but does not pay for them until December. This company would record an expense to their books in the month of December for $3,000.
Which Method Should You Choose
Most small businesses can use whichever method they prefer. However, according to the IRS, a corporation (other than a S-Corp) which averages annual gross receipts of $5 million or more must use the accrual method. It is important to note that you have to choose the same method for treating both income and expense transactions.
Advantages and Disadvantages of Each Method
The advantage of using one method would yield a disadvantage in the other method in many cases. The advantage of using the accrual method is that, since you are recording income and expense transactions in the time period that they actually occur, you can see a truer picture of your financial performance. This is especially true when you compare to a prior period, such as a quarter or year, so that you can easily spot trends in sales and expenses.
However, this would be a disadvantage of using the cash method. In the cash method, your income and expense is recorded when the cash was actually received in or paid out, thus, relying on an arbitrary transaction to take place, such as when your customer decides to pay you or when you have enough cash to pay a vendor.
An advantage of using the cash method is that the way you record your income and expenses are greatly simplified when compared to the accrual method. When you receive a payment you simply record it in your accounting records as a normal journal entry, affecting just the cash and income account. When you pay a bill the journal entry only involves the cash account and the appropriate expense account. Using the accrual method, however, the accounting transaction would be more complex because you have to keep accurate records of who owes the business and who the business owes.
These are reflected on the Balance Sheet using the Accounts Receivable and Accounts Payable accounts, respectively.
Tax Implications of Each Method
Each method will affect your tax obligation in a different way. Using the cash method, it would be possible to purchase supplies, for example, in one calendar year but not pay for it until the following calendar year. In this case, you would not be able to use the expense to lower your taxable income in the first year, however, your profit for the first year would be higher. Using the accrual method in this example, you would be able to show an expense in the first year, thus lowering your taxable income, even though you have not actually paid for the supplies.
As you can see, each method offers certain benefits and each would impact your accounting records and tax obligations in a different way. Since each business is unique it would be advisable to consult with your accountant about which method is right for your business. You can also read more about the IRS regulations regarding the cash and accrual-basis methods here on the IRS website page Accounting Periods and Methods.