The timing of when sales and purchases are recorded in your accounts is the distinction between cash and accrual accounting. Cash accounting only records revenue and expenses when money is exchanged, but accrual accounting records revenue as soon as it is earned and expenses as soon as they are billed (but not paid).
We’ll go through both approaches in depth, as well as how they might effect your business.
Cash basis accounting
Revenues are recognized when cash is received, and expenses are recognized when cash is paid, according to the cash basis of accounting. Accounts receivable and payable are not recognized under this technique.
Because it is simple to maintain, many small businesses choose to adopt the cash basis of accounting. There is no need to manage receivables or payables, and it is simple to tell when a transaction has occurred (the money is in the bank or out of the bank).
The cash technique is also useful for tracking how much cash the firm has on hand at any particular time; you may check your bank balance to see how much cash you have on hand.
Furthermore, because transactions aren’t documented until cash is received or paid, the income of the business isn’t taxed until it reaches the bank.
Accrual basis accounting
Revenues and expenses are recorded when they are earned, regardless of when the money is actually collected or paid, according to accrual accounting. For example, rather than recording income when you are paid, you would record revenue when a project is completed. This is a more popular method than the cash method.
The accrual basis has the advantage of providing a more realistic image of income and expenses over time, as opposed to cash accounting, which cannot provide a long-term view of the business.
The disadvantage is that accrual accounting does not provide visibility into cash flow; a company can look to be profitable while actually having empty bank accounts. Without proper cash flow monitoring, accrual basis accounting can have disastrous implications.
It’s worth noting that many companies keep their books on a cash basis yet file their taxes on an accrual basis. When it comes to tax preparation, they take the necessary measures to convert cash basis accounting to accrual accounting.
Diagram comparing accrual and cash accounting
Diagram comparing accrual and cash accounting
The effects of cash and accrual accounting
It’s vital to understand the differences between cash and accrual accounting, but it’s also necessary to put them into context by considering the immediate implications of each technique.
Consider how cash and accrual accounting effect the bottom line in different ways.
Imagine you perform the following transactions in a month of business:
Sent out an invoice for $5,000 for a web design project completed this month
Received a bill for $1,000 in developer fees for work done this month
Paid $75 in fees for a bill you received last month
Received $1,000 from a client for a project that was invoiced last month
The effect on cash flow
The profit for this month would be $925 if you used the cash basis technique ($1,000 in income minus $75 in fees).
The profit for this month would be $4,000 using the accrual technique ($5,000 in income minus $1,000 in developer fees).
The accounting process utilized in this case has an impact on the look of the income stream and cash flow.
The effect on taxes
Assume that the events described above occurred between November and December of 2017. One of the key distinctions between cash and accrual accounting is the tax year in which income and expenses are recorded.
Income is recorded when it is received in cash basis accounting, whereas income is recorded when it is earned in accrual accounting.
Following the example above, if you invoice a client for $5,000 in December 2017, you would record that transaction as part of your 2017 revenue (and so pay taxes on it), even if you don’t receive payment until January 2018.
The IRS mandates you to adopt the accrual method if your company (other than a S corporation) has averaged more than $25 million in gross receipts over the last three years.
If your company does not meet those requirements, you are free to use the cash method.
However, for small enterprises that do not have goods, the cash system usually works better. If you have a lot of inventory, your accountant will undoubtedly advise you to use the accrual approach.
To modify your accounting procedures, you must submit Form 3115 to the IRS for approval.