Cash vs Accrual Accounting – Which is Best for Your Business?
The accounting method you choose can have a significant impact on your business. Recording your financial transactions in the most efficient way will help you make better business decisions. There are two main methods that companies use to keep track of their income and expenses. These two systems are cash accounting and accrual accounting. The accounting method that’s best for your business will depend on your needs and your objectives. Both accounting methods will be discussed below to help you decide which one is better suited to your business.
Cash basis accounting
Cash basis accounting involves your business cash flow. This accounting system is based on recorded transactions at the point that cash is exchanged. Your business income is recorded when someone pays by cash, check or credit card. Business expenses are recorded when you make payments by credit card, cash or check.
Accrual accounting definition
The definition of the accrual accounting method is where a record is made when the transaction takes place, instead of when there is an exchange of cash. For instance, if your business earns income in March but doesn’t get paid until April, this transaction will be recorded in March, based on accrual accounting.
How cash accounting works
Cash accounting is regarded as a simpler type of accounting when compared to accrual accounting. This is because recording cash at the time of exchange is normally easy and uncomplicated. However, there are downsides to using the cash accounting method. The main disadvantage is that cash accounting does not provide the most accurate picture of your company’s profitability and budget.
- Using cash accounting in your business
Cash accounting concentrates on the money that’s deposited and the cash that’s received. Expenses are recorded when you pay your vendors, suppliers or anyone else for business related products or services. For example, if you own a restaurant and bought a new refrigerator on credit in July and paid for it by check or cash in August, you would record the payment in August under the cash accounting method.
- Benefits of the cash accounting method
The main aspect of the cash accounting method is the focus on cash flow. This type of accounting can be inexpensive for businesses and is particularly useful for partnerships or sole proprietorships.
Here are some advantages of using the cash accounting method:
- Clear focus on cash flow
Cash accounting shows you the cash inflows and outflows of your business. This accounting method involves recording your revenue and expenses when they show up in your business bank account. Therefore, you will always have a true picture of the amount of cash reserves your business is working with when you use the cash accounting method.
- Fewer resources are required
Generally, the cash accounting method is used by small businesses and those who are self-employed because of its simplicity in comparison to the accrual method. As the cash accounting method is straightforward, it’s not necessary to hire accountants or bookkeepers. This makes the cash accounting option more suitable for businesses with limited budgets. If you plan to do your own accounting, the cash accounting method is simple and it will also help you to keep your costs down.
- Tax benefits
There can be tax benefits to using the cash accounting method. Using this method, any customer payment you receive in the current year for any projects that were completed in the previous year would be counted as income for the current tax year. As a result, your net income would be reduced and you could be liable for a lower tax payment for the previous tax year.
- The downsides of cash accounting
Cash accounting is beneficial for providing accurate details about how much money your business has in the bank but there are also negatives to using this method, including:
- Incompatible with generally accepted accounting principles (GAAP)
GAAP are commonly followed accounting rules, frameworks, standards and guidelines that accountants use when preparing financial statements for U.S companies. Incorporated companies must use the accrual accounting method under GAAP, when reporting their financial transactions and keeping their books. This means that the accrual method can be seen as a more legitimate way to record financial transactions. The exception to this perception is where you operate a small business.
- Inaccurate portrayal of your business financial position
Cash accounting may be suitable for your business if you do not have plans to expand anytime soon. However, if you’re thinking about hiring staff and growing your business, the accrual accounting method may be more suitable for you. This is because the cash accounting method can provide a false picture of how profitable your business is. Cash accounting does not take into consideration when a transaction happens and when goods and services are delivered. For instance, your business may receive large amounts of payments during August, however your overall sales have been decreasing since June. In this situation, you will record a positive cash flow when using the cash accounting method. However, your business could still be losing money because of the decrease in sales.
- Tax implications
The cash accounting method can be useful when dealing with income but can be detrimental to your cash flow when it comes to expenses. For example, if your business incurs $1,000 of expenses in 2017, but it does not pay these expenses until 2018, you’ll be unable to take away the expenses for the 2017 tax year, which is the year they were actually incurred.
- Difficulty in financial planning
Using the cash accounting method makes it difficult to get an accurate overview of your operating expenses and profit on a month-to-month basis. This method focuses on cash that’s paid and received, instead of matching earned revenues and expenses that have been incurred month-to-month.
How accrual accounting works
The accrual accounting method is used when products are shipped or delivered or when you complete a service. According to the IRS:
“If an inventory is necessary to account for your income, you must generally use an accrual method for purchases and sale”.
This rule typically relates to businesses that have gross receipts of over $1 million per annum.
- Using accrual accounting in your business
When using accrual accounting, you record all transactions irrespective of whether cash has been exchanged. This is in contrast to cash accounting where income is recorded when cash is received. An example of accrual accounting is where you sell a sofa to a customer using store credit in November and this transaction is recorded right away, as a line in accounts receivable. Although the customer may not be required to make their first payment until December, the transaction will be recorded as business income for November.
This principle also applies to products you buy on credit. If you buy inventory on credit in May, this is recorded as an expense in May, even if you are not required to make a payment until July.
Benefits of the accrual accounting method
The following are some advantages of using accrual accounting:
- Defer tax liability
You can receive some flexibility in relation to paying your taxes when using the accrual accounting method. This method allows you to delay paying taxes even if you receive an advance payment. For example, if you get paid in advance in 2017 for work you agree to do by the end of the following year, you’re able to defer paying taxes until the subsequent tax year. The IRS provides guidelines in relation to reporting payments you have received in advance under the accrual accounting method.
- Match income-related expenses
You are able to gain a clearer view of your business profitability and activities when using the accrual accounting method. You can use accrual accounting to determine how profitable your business has been during a particular month or year. This is also the case where your business provides store credit or bills customers after you’ve carried out a service. The same principle relates to business expenses such as insurance which can be used at a later date after payment.
The downsides of accrual accounting
The following are disadvantages of using the accrual accounting method:
- Requires additional resources
Accrual accounting can be complicated and as a result, you will likely need accountants or bookkeepers to manage your records. Recording your revenue before you receive the money means that you will need to keep an eye on your cash flow separately, to ensure that you can cover your liabilities on a monthly basis. This level of complexity and the need to hire financial experts makes this type of accounting less popular amongst small businesses.
- Ignores cash flow
When using the accrual accounting method it’s unlikely the cash from your sales will match the revenue being reported on your books. This means that if your income statement reflects hundreds of thousands of dollars in sales, you will see a lesser balance in your bank account because customers may not have paid you. Therefore, accrual accounting is not the most efficient way to track your business cash flow.
Which accounting method is best for your business?
We have reviewed the differences, benefits, and disadvantages of cash accounting and accrual accounting above. If you’re still unsure about which method would be the most suitable for your business, the following tips will help you decide.
The cash accounting method is easier to maintain because records are only made when you receive a cash payment or pay an expense. It requires no special accounting knowledge and you can keep track of your cash flow in a simple format.
The accrual accounting method is more complex because you’ll need to make more entries and have a deep knowledge of accounting rules. It’s likely that you’ll need to hire a financial professional to assist with this type of accounting. However, you could use accounting software like QuickBooks for accrual accounting.
If your business makes less than $5 million per year in sales you can choose to use either cash accounting or accrual accounting. You are required by the IRS to use accrual accounting for inventory if your business stores merchandise or inventory to sell to consumers.
- Financial overview
If you want to have a clear picture of how your business is performing, you should opt for the accrual accounting method. Even though the cash accounting method shows you the funds in your bank account, it’s limited in providing quality information about the overall health of your business.
Using the accrual accounting method will give you a better overview of your business. However, accrual accounting is deficient in relation to informing you about the amount of cash you have available. Therefore, you’ll need to keep a close eye on your bank account if you use the accrual accounting method to avoid incurring debt your business may not be able to afford.
The accrual accounting method typically provides more flexibility in relation to reducing your company’s tax burden. This is because your business has a better chance of controlling when you invoice your customers. To reduce your tax bill using the accrual accounting method, you could send invoices in the lower income year to reduce your tax bill in the high income year. Additionally, you can make a request to your vendors, suppliers, and creditors to send their invoice prior to or after January 1 to get the most benefit from tax flexibility.
To save on tax when using the cash accounting method, you can attempt to get payment throughout what you think will be the lower income year to reduce your tax bill in the higher year. In addition, you could pay expenses throughout the higher income year to raise your deductible expenses in the year you may have to pay more tax.
The best accounting method for your business depends on a number of factors. When choosing between cash and accrual accounting, you should consider the number of resources you can dedicate to your business accounting. Using accounting software can make both of these accounting methods easier.
Your accounting software shouldn’t only make your business finances simpler but it should also integrate with the other platforms used to run your business. Deputy integrates with the leading accounting software to provide you with details about labor costs for your hourly workforce. To see it in action for yourself, click on the link below to begin your very own free trial (no credit card required!)