How to Choose: Cash vs Accrual Basis Accounting

How do you decide between cash-basis and accrual-basis accounting methods, and what legal rules apply to each? This choice can greatly affect your financial reporting and tax responsibilities, so gaining a solid understanding of each method is important to ensure you’re making the right decision for your business.

Understanding Cash Basis Accounting

Cash basis accounting, a straightforward method, involves recording income and expenses as they occur in real cash transactions. Simply put, if you get paid by a customer today, that income is recognized today. Similarly, if you pay a bill today, that expense is recorded today.

This approach is often the choice of small businesses because of its simplicity and ease of management. Plus, it’s typically more cost-effective, especially if you’re outsourcing your accounting tasks. Cash basis accounting accurately reflects your actual cash flow, making it easier to track your available cash at any point in time.

However, it’s crucial to understand that cash basis accounting has its limitations. For example, it doesn’t offer a comprehensive view of your financial well-being since it doesn’t consider revenue that you’ve earned but haven’t received yet.

Exploring Accrual Basis Accounting

Moving on to accrual basis accounting, it’s a bit more complex. This method records income and expenses when they happen, even if the money doesn’t change hands right away. It offers a more detailed look at your finances because it keeps track of what you’re owed and what you owe.

Bigger businesses usually use accrual accounting, and it’s accepted as a standard by GAAP. It links income with the expenses that go with it, showing a more precise picture of how profitable your business is.

But, remember, while accrual accounting gives you a closer look at your finances, it can be a bit harder to manage. Sometimes, it might mean you pay more in taxes because you report income when you earn it, not when you get paid.

Let’s use an example to explain the difference. Imagine you run a company selling machinery. If you sell $5,000 worth of machinery, with the cash method, you only record it when you actually get the money, which could be months later.

With the accrual method, you put that $5,000 on your books the day you make the sale, even if you won’t see the cash for days, weeks, or months. It works the same way for expenses. If you get a $500 utility bill, the cash method waits until you pay it, but with the accrual method, you mark it as an expense when you receive the bill.

Things to Consider:

• Accrual accounting is required for companies with average revenues of $25 million or more over three years. 
• If you’re in a business where payments are often delayed or you have lots of unpaid bills, accrual accounting could be better. This is especially true if you deal with things like inventory because cash accounting doesn’t properly account for cost of goods sold and sinks gross profit.
• If you run a small store or a restaurant where you get paid right away, cash accounting is simpler and makes more sense.
• Another crucial factor is tax planning. With accrual accounting, you might have to pay taxes on money you’ve earned but haven’t gotten yet. On the flip side, you can deduct expenses before you pay them, which can lower your taxable income. Here’s an easy example to explain this:
  
  Let’s say you’re using accrual accounting, and it’s December 31, the end of your fiscal year. You might have recorded income that you haven’t actually received yet. Even so, you’ll have to pay taxes on that income, whether you’ve received it or not. It’s important to remember this.
  
  However, there’s an upside to this method. It lets you deduct expenses before you’ve actually paid them, which can lower the amount of income you’ll be taxed on. For instance, if you got a bill on December 28, even though you don’t have to pay it for three months, you can still count it as an expense for that year.

Transitioning from Cash to Accrual Basis Accounting

Usually, when transitioning from cash to accrual accounting, you’ll need to maintain two sets of books for a while to meet tax and financial reporting rules.

To begin, you should examine your current balance sheet and income statement to see how you currently report assets, liabilities, revenues, and expenses. Then, identify which accounts need adjustments to switch from cash to accrual accounting. This often involves adding accounts to your chart of accounts, like accounts receivable and accounts payable, as well as prepaid accounts for both income and expenses.

Finally, you’ll have to make the necessary adjusting entries to shift from cash to accrual accounting. For instance, under the cash method, you wouldn’t record a sale until you received the payment. But under the new accrual method, you’ll record the sale as revenue with a corresponding accounts receivable entry, which stays on your books until you receive the payment. So, these entries will need to be made.

Switching methods can be quite complex, so it’s important to approach it with full awareness. It’s essential to understand that there is no universal solution for the cash vs. accrual accounting decision. The best choice depends on your specific business situation, objectives, and regulatory demands. You may need to hire some outside help, like an accounting firm, to help accomplish this.

About the author, Amanda Hendren

Amanda Hendren is a seasoned professional with over 10 years of expertise in bookkeeping, Human Resources, and payroll management. As the CEO of Accountable Numbers, she leads a team of dedicated professionals in providing comprehensive financial services to businesses of all sizes. She holds a Bachelor’s degree in Accounting and a Master’s degree in Business Administration.

Amanda's passion for numbers and meticulous attention to detail have been instrumental in helping her clients maintain accurate and organized financial records. Her extensive knowledge and practical experience in accounting enable her to deliver strategic financial guidance that helps businesses optimize their operations and achieve their financial goals.