Today, businesses and companies of every type, big or small, have to record all their financial transactions in a ledger. The process is also called Bookkeeping, where you have to add all your expenses and income in one central. This is important for tracking business performance in both the short and long term. More importantly, Bookkeeping is essential if you want to claim tax deductions at the end of the year. There are several DIY bookkeeping approaches available. But if you’re someone with less finance knowledge or you prefer someone else doing your Bookkeeping, you can check out virtual accountant services providers like Overdraw to handle the job for you.
When we talk about recording financial transactions, there are technically two approaches that you can choose from. Cash basis accounting and accrual basis accounting. This article will talk about cash vs. accrual accounting and which one should you choose for your business. But first, let’s talk about what cash basis and accrual basis accounting are.
What Is Cash Basis Accounting
Let’s make it simple; Cash basis accounting is when you recognize revenues when the cash is received. In the same way, expenses are recognized when the amount is paid. In cash basis accounting, there is no concept of recording account receivables and account payables. This method is highly beneficial for small businesses as it makes the tracking of available cash easier. On the other hand, this method also makes it easier to determine when a transaction has occurred.
However, there are some severe drawbacks to the cash accounting method. One of the most significant disadvantages is the lack of financial state in the long term. Let’s say your company had abysmal sales in February. In the same month, you received past due payments of $5000 for the work you performed in October. Your book will show that your business did well with cash basis accounting, but in reality, that is not the case. In short, cash accounting lead you to overstated income and understated expenses.
Cash basis accounting is considered more preferable in scenarios where you might have to apply for a governmental scheme like the PPP Loan or have to account for retained earnings at the end of your financial period.
What Is Accrual Accounting
With Accrual basis accounting, income or revenue is recognized when you raise an invoice for the customer, regardless of when you actually receive the cash. In the same way, expenses are recognized as soon as you receive an invoice or a bill, regardless of when you actually incur them. Even though accounting’s accrual method is much more complicated to learn than the cash accounting method, it has definite perks over cash accounting. One of the most significant benefits of Accrual basis accounting is that it shows a clear reflection of your business’s financial health in the long term. It does it by merely matching the timing between revenues and expenses.
Accrual basis accounting is mostly opted by more prominent companies or enterprises because it enables them to create cash flow charts to manage working capital effectively during slower times and resources during the peak periods. This accounting method also gives these companies an immediate insight into customers’ spending habits and income trends.
It’s not just the more prominent companies and enterprises that benefit from accrual accounting. Investors and lenders typically look for financial statements based on accrual accounting because it enables them to decide if their investment is going to be beneficial or not. So if your business or company follows the Accrual basis accounting method, there’s a high chance of investors willing to invest in your industry.
Differences Between Cash Basis and Accrual Basis Accounting
As mentioned above, the fundamental difference between cash accounting and accrual accounting is the time of recording revenues and expenses. Here is a table showing some key differences between cash and accrual accounting.
Cash Basis Accounting
Accrual Basis Accounting
|Revenues are not recognized unless the cash is received.||Revenues are recognized as soon as they are earned, regardless of when you receive the cash.|
|Expenses are not recognized unless they are incurred.||Expenses are recognized as soon as you receive the invoice or bill.|
|Taxes are only paid on the cash that you have received.||Taxes are also paid on the revenue that you have earned but not received as yet.|
|This accounting method is usually opted for by small businesses because they have to look when the money has entered or left the bank.||Bigger enterprises and companies use this method to determine their business’s overall financial health in the long term.|
Effects Of Cash And Accrual Basis Accounting On Cash Flow
Let us explain the effects of cash and accrual accounting on cash flow with an example. The following are the transactions conducted by a business in the month of September.
- Delivered an invoice of $10,000 for a project completed in September.
- Received a bill of $3000 for developer fees of the work done in September.
- Paid $100 for a utility bill received in August.
- Received $1000 payment from a client for the services provided in August.
When we talk about cash basis accounting, we’ll only record the cash that is either received or paid. In this case, we’ll deduct the $100 paid bill from the income received $1000. The profit for this month would be $900.
In Contrast, the accrual basis accounting method will record the revenues as soon as they are earned. The profit recorded in this case is $7000. We have simply deducted the account payables from the account receivable to determine the gain.
This difference also affects the way in which each cash flow statement is made under each accounting method.
Effects Of Cash And Accrual Basis Accounting On Taxes
One of the most significant differences between cash and accrual accounting is how they affect the taxes.
Since you record revenues in cash accounting only when you receive the payment, you will pay tax only on the income that you have received.
However, the case with accrual accounting is different. Let’s follow the above example. Since you had recorded the revenue when you earned it, you’ll have to pay tax on the amount regardless of if you have received the payment yet or not. This is because that transaction is recorded as your income.
Now, since you know what cash basis and accrual basis accounting methods are, it’s time to decide which way you should opt for your business. If your business is a corporation conducting millions worth of transactions each year, then the right choice for you is to go for Accrual basis accounting. In Contrast, if you own a business that is your sole proprietorship and doesn’t hit marks of millions, using the cash basis accounting is the right thing for you.