The Difference is Timing
You know the joke:
“Ask me what’s the most important thing in comedy?”
“What’s the most important thing…”
Timing of when revenue and expenses are recognized is the difference between accrual and cash basis accounting.
Accrual Based Accounting
Under the accrual basis, revenues and expenses are recorded when they are earned, regardless of when the money is actually received or paid. The accrual basis of accounting provides a better picture of a company's profits during an accounting period. The reason is that the income statement prepared under the accrual basis will report all of the revenues actually earned during the period and all of the expenses incurred in order to earn the revenues.
The accrual basis of accounting also provides a better picture of a company's financial position at a moment or point in time. The reason is that all assets that were earned are reported, and all liabilities that were incurred will be reported.
Cash Based Accounting
The cash basis of accounting recognizes revenues when cash is received and expenses when they are paid. This method does not recognize accounts receivable or accounts payable. Many small businesses opt to use the cash basis of accounting because it’s easy to determine when the transaction has occurred (the money is in the bank or out of the bank), and there is no need to track receivables or payables. The cash method is also beneficial in terms of tracking how much cash the business has at any given time; you can look at your bank balance and understand the exact funds available. Also, since transactions aren’t recorded until the cash is received or paid, the income isn’t taxed until it’s in the bank.
The Effects of Cash and Accrual Accounting
Understanding the difference between cash and accrual accounting is important, but it’s also necessary to put this into context by looking at the direct effects of each method. Here’s an example of how cash and accrual accounting affect the bottom line differently. Consider the following transactions for a month of business:
- Scott runs a small advertising firm. Between November and December he:
- Sent out an invoice for $5,000 for a completed graphic design.
- Received a bill for $1,000 for printing.
- Paid $75 for web hosting services, which he was billed for during the prior month.
- Received $1,000 from a client for a project that was invoiced last month.
The Effect on Cash Flow
Under the cash basis of accounting, Scott’s profit for this month would be $925 ($1,000 in income minus $75 in fees). On the other hand, under the accrual method, the profit for this month would be $4,000 ($5,000 in income minus $1,000 in printing costs). The accounting method used can affect the appearance of income stream and cash flow.
The Effect on Taxes
Scott’s activity took place between November and December of 2014. Another difference between cash and accrual accounting is the effect on which tax year income and expenses are recorded in. Under the cash basis, income is recorded when Scott received it, whereas with the accrual method, income is recorded when he earned it. Therefore, if Scott used the accrual basis and invoiced a client for $5,000 in December of 2014, he would record that transaction as a part of his 2014 income (and thus pay taxes on it), regardless of whether he receive the payment in January of 2014.
Which Method Should Your Business Use?
Many small businesses with sales of less than $5 million per year can implement either accounting method. Most choose the cash method.
However, you must use the accrual method if:
- Your business has sales of more than $5 million per year, or
- Your business stocks an inventory of items that you will sell to the public and your gross receipts are over $1 million per year. Inventory includes any merchandise you sell, as well as supplies that will physically become part of an item intended for sale.
How Cole Gavlas Can Help
To have an accurate grasp of your business's finances, it’s imperative that you understand what the numbers mean and how to use them to answer specific financial questions. And when making choosing either the cash or accrual method, we can help you be confident in your decision, as well as provide valuable, strategic advice going forward.