Understanding the Major Differences Between Cash Basis and Accrual Accounting

As a small business owner, you must make decisions about how to track the funds coming into your accounts — both for personal accounting purposes and for your tax records. There are two primary strategies for keeping up with your business’s income: cash basis accounting and accrual accounting. You should always track your business’s income using the same method to keep your books as consistent as possible. 

That leads to an important question: Does it really make a difference how you calculate your business income? When it comes to your taxes, it does. 

Cash basis and accrual accounting can show dramatically different results concerning your business’s income from year to year. Knowing which method is right for your small business can help you avoid tax snarls and decrease your odds of facing an audit or, worse, tax evasion penalties. 

What Is Cash Accounting?

Cash basis accounting counts your business’s income and expenses only when cash actually gets exchanged, like when a customer sends payment for an invoice or your company pays for services rendered. The cash method typically means no record exists of accounts payable or receivable, though, which can make it difficult to determine the actual value of a company. Sometimes, a company utilizing the cash accounting method may look healthy and cash-rich even when it does not actually have the resources it needs, for example, or might have multiple bills due during the accounting period. 

What Is Accrual Basis Accounting?

Accrual basis accounting calculates the business’s cash flow — including expenses and invoices paid — as it accrues. Accrual accounting takes place when the transaction gets made, not when payment occurs, meaning the expenses and revenue get matched as they occur rather than getting separated based on when actual payment takes place (as in the cash basis accounting method). Accrual accounting gives a more accurate picture of the business’s financial status, since it provides more information about its current anticipated income and expenses. 

Choosing the Right Strategy for Your Business

Cash basis and accrual accounting each have their place in business operations. Choosing the right one can make a big difference for your company, however, whether you’re looking into selling or transferring it or just need to make sure that you’re properly reporting income, expenses, and other financial statements. 

Working with a trusted tax advisor can make it easier to choose the accounting method that will work best for your business, but here are a few facts about each to help. 

The Benefits and Drawbacks of Cash Basis Accounting

Cash basis accounting offers several benefits. It:

• Makes it easier to calculate how much money the business has on hand at any given time — which can make it easier to make current purchase decisions. 
• Gives you a better idea of exactly how much money you have on hand.
• Helps you track cash flow as it occurs. 
• Offers a simple, straightforward method for calculating income, which can prove easier for your team.

On the other hand, cash basis accounting:

• Is not considered acceptable under the terms of the Generally Acceptable Accounting Principles (GAAP) or the International Financial Reporting Standards (IFRS)
• Does not present as full a picture of profits and losses, especially in the case where payments take considerable time to be made
• Can make it difficult to judge the health of a business or its progression forward.

Say a company has had a slow month for business, but multiple customers pay their invoices during that same period of time. It may thus appear more immediately healthy on financial statements than it really is! 

The Benefits and Drawbacks of Accrual Accounting

Accrual accounting is used more often than cash basis accounting in many businesses. It:

• Helps you better understand your business’s actual profits and expenses, as you can immediately see a full picture of the revenue you can expect as a result of those expenses. 
• Makes it easier to forecast the health of your business, since you can get a better picture of your exact profits and losses over a specific period. 
• Provides better tax records, including the ability to depreciate assets. Often, accrual accounting can help businesses save money on their taxes. 

While accrual accounting has multiple benefits, it does offer some drawbacks. It:

• Can make it more difficult to manage actual cash flow, since it doesn’t always recognize invoices that have not yet been paid. You may have out-of-pocket expenditures while working on a large project, for example, but your client may not pay until you complete the project. 
• May also bring with it significant, difficult calculations, which can make it more difficult to keep up with your overall business expenses and income statements. 

Which Method Is Right for You?

Depending on your business, you may have a dramatically different outlook on which accounting method you need to use. During the accounting period, consider the following:

• The Internal Revenue Service (IRS) mandates that you use the accrual accounting method — not the cash basis method — if you make more than $5 million in sales per year or more than $1 million in gross inventory sales. 
• If you frequently deal with large projects with a large payout at the end, you may prefer to use the cash basis method. Electricians who only collect payout when they finish projects may want to use a cash basis accounting method to help calculate how much money they actually have on hand, for example. 
• If you have predictable revenue or know how much payment you will receive, you may prefer the accrual method. It could help you judge rental income over time, for example. Similarly, a marketing company that collects the same amount from each customer each month might prefer the accrual method. 

You want to make sure you maintain a consistent balance sheet whether you choose the accrual or cash basis method of accounting. Work with an experienced tax advisor to learn more about the right solutions for your business and how they can impact your taxes. 

Additional Questions? Contact the Experts.

Do you have questions about cash basis or accrual accounting, or have other questions about your tax or bookkeeping needs? Contact Silver Tax Group to speak with a tax services expert today.