In order to continue enjoying our site, we ask that you confirm your identity as a human. Thank you very much for your cooperation. Show Understanding the differences and which you should use for your business Want to know if you should choose cash or accrual for your small business? Schedule a free call with one of our accounting experts to discuss the pros and cons for your business. The difference between cash basis accounting vs accrual basis accounting is based on when your revenue and expenses are reflected in your books. Fact: Contrary to popular belief, the difference between Cash and Accrual accounting has nothing to do with the method of payment. In a nutshell, when you receive payment from your customers and then immediately write it down in your books, that’s cash accounting. But if you wait until the product is delivered or service is rendered before you write it in your books, then that’s accrual accounting. The same goes for your expenses. When using cash accounting, If you buy goods but don’t pay for them right away (ie. you put it on credit or negotiate other terms with your supplier) you don’t write it in your books until it’s actually paid for. But if you put it in your books right away (as money owed or an “account payable”) then that’s accrual accounting. It’s best to stay consistent with whichever you choose and the IRS requires companies to keep the same method for an entire year - you cannot switch half-way through (want to switch accounting methods? File IRS form 3115) there are also some hybrids (I’ll talk about these later in this article) Basically, when using cash accounting method, you wouldn’t recognize accounts receivable or accounts payable. Accrual accounting recognizes both of these. On a deeper level, accrual accounting allows you to match up revenue and its corresponding expense starting when the transaction occurs, rather than when payment is transferred. This method lets you understand the current cash flow and compare it to future cash flow (on a transactional basis). Is this giving you a headache? Get rid of the headache by hiring Bookkeeper360 to handle your bookkeeping. Get Started Today Pros of Cash AccountingCash accounting is simple and handy. It allows you to know how much cash you have in the bank in real-time, and you only have to pay taxes on the money you’ve received - you do not need to pay taxes on the money that’s owed to you. Be sure to read the IRS website for specifics. Cons of Cash AccountingCash accounting can have its drawbacks, too. It can give you an inaccurate long-term financial picture of your company. For example, if your business has a lot of money coming in it could lead you to believe you’re having a good month, but in actuality it’s last months sales that are just coming in now. Since cash accounting does not include accounts receivable or accounts payable, it will be difficult to keep track of money when your company does not receive immediate payment or if you have outstanding bills to vendors. This will make it more challenging to manage your cash flow because it will not be clear what's coming in and going out over the next few days, weeks, or months. Pros of Accrual AccountingAccrual accounting gives a clearer picture of your business finances, as described by the Generally Accepted Accounting Principles (GAAP) . Accrual accounting is the best for understanding financial data because it shows how much money you earned and spent (aka your cash flow) within a specific period of time. This shows your cash flow broken up into transactions which is how you will know how well your business is performing - this shows when things pick up and when they slow down. Having your cash flow illustrated through transactions is more finely illustrated with the matching principle. In accounting, the matching principle is defined as matching revenue and its corresponding expense within the same transaction, rather than when the expense or income is actually generated (from a timeline perspective). For example, let’s say in January you buy 1000 units from your wholesaler then sell those units over a year. The sale you made in August is now being linked back to your wholesale purchase in January to show the full circle of your cash flow and the transactions that affect it. Since accrual accounting shows these details, most business owners will choose to switch to accrual accounting at some point within the business lifecycle. By opting for accrual from the start you’ll be ahead of the game. Then once you hit 5 million in revenue, GAAP forces you to use accrual accounting. When you use accrual accounting, you don’t have to pay taxes on orders/services until they’re fulfilled. For example, if you receive prepayment from a client, you won’t be taxed on that prepayment until you fulfill their order or service. This lets your company keep more money in the business until a future tax period. This extra money can help with operations or growth. Cons of Accrual AccountingAccrual can be more work because you have more lines to enter (ie. accounts receivable and accounts payable) and because you need to make sure those lines are posted in the correct period. Since you’re entering these extra lines, you’ll need to pay taxes on them even though you may have not yet received the income or paid for the expense. An inaccurate short-term view is also something to consider since the cash method gives you a better view of your bank funds. This means that accrual accounting can be financially devastating to a small business - your books could show a large amount of revenue when your bank account is completely empty. While accrual can be more work, you can set up accounting software to do the heavy lifting. Our preferred accounting software is Xero
Maybe a hybrid is best for your business?Some small businesses choose a hybrid of cash accounting and accrual accounting - they might use accrual for inventory but cash for income and expenses. You could also keep two sets of books - you could operate your business on accrual accounting, but then report to the IRS with cash accounting (when you report your books to the IRS with cash accounting, you don’t have to pay taxes on any of your product or services that are prepaid) If you’re still unsure on which accounting method to use, schedule a free call with one of our accounting pros today. Starting your business is reason enough for stress. On top of that, dealing with your finances and accounting on your own can only add to the headache. At KPMG Spark, we want to help you simplify the process and we’ve put this guide together to help you better understand your accounting. Here, we’ll lay out the differences between the cash and accrual accounting methods and how to choose which is best for your business. Cash and accrual accountingCash basis accounting and accrual basis accounting are two main types of accounting that businesses employ to keep track of their finances and for tax purposes. While they both have their pros and cons, depending on factors within a business (like inventory and the size thereof) you may be inclined or required to use a particular accounting method. To put it simply, cash accounting generally recognizes your revenue and expenses exactly when the cash enters or leaves your bank account while accrual accounting generally recognizes revenues and expenses when they are earned or incurred. Here, we will dive into the differences between the two and how you can decide which one to use for your business. Cash basis accountingCash basis accounting is used largely by small businesses that need to keep track of their cash flow at all times. It tends to be easier as there generally is less to track; many small businesses and a large portion of KPMG Spark clients use this method because of its simplicity. Cash basis accounting generally recognizes all revenue as it is received and all expenses when the money is spent. This means that whenever you look at your bank balance, you know exactly what resources are at your disposal. It also means that your revenue generally will not be subject to tax until the cash is in the bank (although there is also a concept of ‘constructive receipt’ for certain amounts available upon demand). While simple and easy to maintain, the cash basis of accounting does not always show an accurate image of the true financial state of a business. For example, if your company appears to be cash-rich but has large amounts of account payables and has yet to pay them, your financial standing reflected in your bank accounts may look inappropriately good. In this case, investors might think your company is about to make a profit and continue growing but in reality, it may be losing money because of the unpaid accounts payable. Accrual basis accountingOn the other hand, accrual accounting recognizes revenue when it’s earned and expenses when they are billed (or in some cases as earned by the counterparty). This type of accounting is more popular among larger businesses but is typically more complicated and, at times, more labor-intensive. An example of accrual accounting would be if another entity or person owes your company money; if you have already sent an invoice to your customer, then you would record the amount owed by your customer as revenue, even if the customer hasn’t yet paid you. This method is mostly used by larger businesses and is even required for businesses with average revenue exceeding 26 million dollars a year. Accrual accounting tends to provide a more realistic financial view of a business over the long term and is especially helpful for companies with large amounts of inventory. Even though the accrual method tends to be more popular among large businesses, it does have its drawbacks. Unlike the cash basis method, the accrual accounting method does not actively track your cash flow. This can be very dangerous for businesses with a cash shortage in the short term as they can end up spending money they do not actually have because they appear to be profitable in the long term – stated differently, they have reported lots of revenue, but they haven’t been paid, so there is no cash in the bank. While using the accrual method, it is imperative to have someone tracking the incoming revenue and outgoing expenses to understand the actual cash position of the business. Payroll accrualAn aspect of accrual accounting that highlights its complexity is payroll. Assume a company pays its employees on the fifth of the month for the prior month’s work. Because your employees have already earned their pay for the month, under the accrual method you would need to account for the pay you owe to them at the end of the month, days before they are actually paid – the amount owed is an accrued payroll liability for your business. If you expand this concept beyond payroll – for example to utilities, rents, service contracts, leases, loans, etc. - this begins to create a long list of expenses that need to be recorded as accrued expenses (or payables). This illustrates why accrual accounting is more labor-intensive and more expensive. ProfitWhile tracking expenses and trying to determine net profit, the two accounting methods, cash v accrual, will yield different results. Under the circumstances listed below, we will assess the profit of a particular month. |
Explain the difference between the cash accounting method and the accrual accounting method.
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