As a business owner, accounting methods may not rank that high on your list of passions, but understanding cash basis accounting vs. accrual accounting can be vital to your company’s health.
Keeping track of your cash flow can save you time and money, not only helping you during tax season but also helping you to streamline and strategize in every area of your business.
Cash basis and accrual accounting represent the two major methods of accounting used by financial professionals. If you’re not familiar with these terms, we’ll help you understand their definitions and differences, as well as their impact on your business.
Cash Basis Accounting
Cash basis accounting is the simpler of the two accounting methods. In cash basis accounting, transactions are recorded as cash changes hands. In other words, income is reported when cash is received, and expenses are recorded when you pay your bills.
This means that cash basis accounting doesn’t require any specialized accounting techniques. This method can be done as easily as balancing your personal checkbook.
For business owners, it also makes it easy to identify when transactions occur, since these will be recorded on your bank statements, too.
In accrual accounting, income and expenses are recorded when they occur, regardless of when money actually changes hands. In fact, it’s not uncommon to record income before you receive payment or to record future expenses before they occur.
Admittedly, this method is slightly more complex than cash basis accounting, but it offers the benefit of greater accuracy. Accrual accounting provides a thorough record of your company’s revenue and liabilities.
One of the reasons that larger companies rely on accrual accounting is that this method gives them a better, more accurate picture of their financial health.
The Effect on Taxes
The differences between cash basis accounting vs. accrual accounting can be particularly noticeable when it comes to paying your taxes. Basically, you’ll pay tax on every source of income, though each method records income slightly differently.
Cash Basis Accounting and Taxes
Cash basis accounting remains the most straightforward method. Income is recorded only when you receive payment, which means that you’ll pay taxes on the cash your business receives.
For example, if your company sells a product to a customer in December of 2021 and receives payment in January of 2022, this transaction would not be recorded on your business income tax return until the following year.
In other words, with cash basis accounting, your company will only pay tax on the cash you receive, rather than on future transactions.
Accrual Accounting and Taxes
This is where accrual accounting can be a bit tricky, tax-wise. Remember that with accrual accounting, you record income and expenses as they occur, rather than when you actually receive payment. This means that you’ll pay tax on all business income regardless of whether you’ve actually received the money for the transaction yet.
Returning to our above example, if you sell a product to a customer in December of 2021 but don’t receive payment until January of 2022, you would still pay income tax on that sale, even though payment was not rendered during the same tax year.
Understandably, this is why it’s important for companies to manage their finances appropriately to prepare for taxes. One of the ways business owners keep a handle on their tax planning is by choosing to outsource accounting to an online bookkeeping team.
These online accounting firms can provide preparation and guidance to ensure you hold back enough money to cover your tax payments. They can often help you strategize to manage your tax obligations, too.
The Effect on Cash flow
When comparing cash basis accounting vs. accrual accounting, it’s important to understand how each method can impact your cash flow in surprisingly different ways.
Let’s consider the following example, and then look at how each accounting method would calculate cash flow:
- You sent an invoice to a client in an amount totaling $500
- You received a bill for $100 for the month
- You paid $20 in fees for a bill you received the previous month
- You received $100 from a client for an invoice sent the previous month
Pay attention to when money actually changes hands in our above example. This will greatly impact how cash basis accounting and accrual accounting will record cash flow.
Cash Basis Accounting and Cash Flow
Cash basis accounting will look at the example above and focus on the money changing hands. In our example, the only actual transactions that are recorded are the $20 you paid in fees and the $100 you received from your client, meaning your total profit is $80.
But do you see the danger of this method? Cash basis accounting records cash flow as $80. But look at your upcoming expenses: you have a bill in the amount of $100. You won’t be able to cover this expense until your client pays their $500 invoice.
This means that despite the simplicity of cash basis accounting, it has the potential to overstate your financial health at any given time. With that in mind, let’s take a look at how accrual accounting would handle this same example.
Accrual Accounting and Cash Flow
While cash basis accounting selectively records the transactions in the above example, accrual accounting would record each one, regardless of when money is actually received.
Therefore, in our example, accrual accounting will record income in the amount of $600 ($100 received + $500 invoice), and expenses in the amount of $120 ($20 spent + $100 bill). The final profit for the month would therefore be $480 ($600 – $120 expenses).
This is a sizable difference! The same company would record profits of $80 or $480 depending on their accounting method.
In comparing cash basis accounting vs. accrual accounting, you can see how accrual accounting provides a more comprehensive picture of a company’s revenue and liabilities but doesn’t necessarily provide an accurate picture of your actual cash on hand.
This is why cash basis accounting works best for small companies or those with simple transactions, while larger companies prefer the accrual method.
Choosing the Right Method for Your Business
Choosing between cash basis accounting vs. accrual accounting can seem challenging, but there are some basic considerations that can help you to decide.
Keep in mind that if your business earns more than $5 million in annual sales, you must use the accrual method. But if your business earns less than $5 million, you may choose between these two methods.
When to Use Cash Basis Accounting
Cash basis accounting can be beneficial for smaller companies and startups. This can actually be a great method for eCommerce bookkeeping. If your company relies on a lot of online sales, cash basis accounting can make it easier to keep track of your books.
You should consider cash basis accounting if your business fits any of the following criteria:
- Your company is small
- You carry little inventory
- You produce products on demand
- You run a small eCommerce business (or an Amazon FBA store)
Some small companies start out using the cash basis method, then switch to the accrual accounting method after their businesses start to grow. This is perfectly legitimate, though you may need the assistance of a financial professional to help you make a frictionless transition between methods.
When to Use Accrual Accounting
Accrual accounting is the preferred method for larger businesses, but it can also provide an accurate solution for businesses that do any of the following:
- Conduct high-volume business
- Maintain a lot of inventory
- Conduct larger projects with multiple phases
- Pay contractors for portions of a project
Construction companies, for example, can benefit from accrual accounting to help manage the money they receive from clients, as well as the expenses incurred from equipment and subcontractors.
Similarly, web developers can benefit from the accrual method, helping them manage larger, complex projects that require multiple phases to complete.
Understandably, this can be a bit intimidating for business owners who already have a lot on their plates. This is why many entrepreneurs choose to outsource accounting for small business financial services.
An online accounting firm can provide assistance with your accounting and bookkeeping needs, ensuring that your books stay accurate and up-to-date.
Getting Behind? We’re Here to Help!
Hopefully, now, you’ve got a better grasp on cash basis accounting vs. accrual accounting. But what if after reading this article, you realize you’ve been doing it wrong? And what if you’ve been putting your books off until “tomorrow” and you’re not sure what to do?
First, don’t panic! At Xendoo, we’ve helped countless clients get caught up and back on the right track. The online bookkeeping features offered by our skilled team can ensure that you have all of the help you need to manage your books, monitor your cash flow, and prepare for tax season.
If keeping track of your books gives you anxiety, don’t wait another day. Our free, no-obligation trial can show you how your business can thrive with accurate books. Sign up today and get back to managing your business!