When I first learned about accounting methods, it felt like I was reading a who-done-it mystery.
I’d think I understood how they worked and then realized I was still confused.
As I put accounting terms into practice and pored over accounting books, they helped me unravel the seemingly mysterious side to accounting. Initially, cash basis accounting made sense to me, while accrual basis accounting seemed foreign and strange.
If you feel that way, too, when first learning how these accounting methods work, the differences between the two are actually straightforward and easy to understand, that’s good news if you’re concerned about which one to use for your business!
Both methods have their pros and cons, but you’ll discover after reading this post whether the accrual basis accounting is right for your business.
What is accrual basis accounting?
When using the accrual basis accounting method, you report sales as revenue and post associated accrued expenses (considered as accrued liabilities). The client hasn’t paid for your product or service, and neither have you paid for the costs to produce it.
In other words, there hasn’t been a cash exchange, but you register financial transactions (debits and credits) as they happen. Moreover, you have detailed records of accounts receivables and payables you can review any time you want.
Accrual basis accounting is compliant with the GAAP (Generally Accepted Accounting Principles) and IFRS (International Financial Reporting Standards).
As an example, let’s say a customer orders $1,000 worth of products on February 1st. When using accrual basis accounting, you would record the $1,000 as income even though the customer may not pay the bill until March 15th.
Some businesses combine accrual basis accounting and cash basis accounting.
Accrual basis vs cash basis accounting
This table compares accrual basis and cash basis accounting. You can readily see their differences to fast track your knowledge of the two accounting methods.
|Accrual Basis||Cash Basis|
|Business owners have a clearer picture of profit for a more accurate portrayal of how well a company is doing within a longer timeframe.||Business owners know how they’re doing within a shorter timeframe. However, a month with higher cash flow could reflect sales from the previous month.|
|You post revenues when earned and expenses when incurred (billed).||You post revenues when you receive cash, and pay expenses.|
|Harder to track cash flow (income and expenses are accumulated, not received or paid). You must monitor cash flow separately to make sure there’s enough money to pay bills.||Easier to track cash flow (cash in, cash out) because you can monitor funds in your bank account.|
|More bookkeeping required as a double-entry bookkeeping system is needed.||Minimal bookkeeping required since you use a single-entry bookkeeping system.|
|Business owners can anticipate revenues and keep an eye on liabilities.||Business owners do not have account-receivables and account-payables records to track sales.|
|Pay tax on recorded revenues.||Pay tax on revenue received.|
|Must use accrual basis accounting when sales are more than $25 million per year.||Can use cash basis accounting when sales are less than $25 million per year.|
|An accountant is usually needed to oversee accrual basis accounting.||Little financial accounting knowledge is needed.|
|Suitable for large businesses with extensive inventory and that operate using credit transactions.||Suitable for small businesses such as sole proprietors and partnerships with little inventory and that transact exclusively using cash, checks, and credit cards.|
Is accrual basis accounting right for your business?
The method works best for business owners who provide goods and services on credit (there is no cash exchange). Investors view accrual basis accounting as the most valid accounting system to reflect a company’s current financial position. Why? Because income statements reflect a more thorough review of its operations.
The accounting method that works best is one that is accurate, consistent, and supports your business operation.
Public companies and organizations prefer using accrual basis accounting when they are required to file audited financial statements.
Keep in mind that, with this accounting method, at the end of a tax year, you’re obligated to pay tax on reported revenue even if it’s still unpaid. Equally important to note is that the accrual basis accounting method is harder and more expensive to implement.
In most instances, this accounting method provides a clearer picture of a business’s financial health. You can see when sales increase and decrease within a quarter of a full year. Likewise, you can identify consumer spending patterns and determine when your business’s peak season occurs.
When deciding on an accounting method to use, you must choose the one that suits your business’s needs. If you anticipate that your company will grow quickly, the accounting method should compliment your current and future needs. As your business changes, it should be able to adapt to growth.
If you aren’t sure which method is best, contact a tax professional for advice.
Choose an accounting method you’re comfortable with
Accrual basis accounting offers benefits to business owners that the cash basis method does not. Namely, you can report income and expenses before income is collected and expenses disbursed. Consequently, business owners get a more accurate picture of their company’s financial health.
Nevertheless, accrual basis accounting is a more complicated bookkeeping system compared to the cash basis method, and you’ll need to monitor your cash flow carefully. The reason being your records can show profitability, but your checking account may have a low balance.
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