Getting your accounting right is key to running a successful business. Keeping accurate tabs on your income and outgoings will ensure your business continues to grow — and helps you avoid overspending.
But successful accounting isn’t always as easy as it sounds. You need to find a method that works for both you and your business on a long term basis. There are two accounting methods you can use for your business: cash basis accounting and accrual basis accounting. In this blog post, we’re going to explore cash vs. accrual basis accounting.
Choosing the most suitable method for your business will help you maintain your profits over the long term, be smarter with your tax returns, and make more informed business decisions.
What is cash basis accounting?
In the world of accounting, the word ‘cash’ doesn’t refer to physical coins and notes, but the amount of money your business has on hand at any time. Under a cash basis accounting structure, you can track payments in and out of your business — at the moment the cash is received.
For example, if you send an invoice to a client in December, but they do not pay you until January, you would only record the income from that invoice in January when the money has reached you.
Similarly, if a supplier sends you a bill in January, but you wait until the due date in February to pay it, you would record the expense from that bill in February.
Pros and cons of cash basis accounting
Cash basis accounting certainly has its advantages for some businesses, but it is not the right option for everyone.
Simple to use: cash basis accounting tracks your business finances in the same way you would track your personal finances. That makes it easy to understand, which is especially important if you are a sole proprietor or micro business.
Great for cash flow: tracking how much cash is coming in and out of the business as it happens gives you a very accurate picture of cash flow — a vital profitability metric.
Potential tax benefits: thinking back to our earlier example, if you send an invoice in December, but the client doesn’t pay until January, you avoid paying tax on that invoice until it is actually paid. Cash basis accounting helps ensure you always have the cash to cover your tax liabilities when they are due.
Inaccurate over the long term: looking back at your year, you may see that April and November were strong profit months. However, cash basis accounting doesn’t give you the full picture. You may have realized revenue from invoices sent in previous months or paid a lot of bills in an otherwise profitable month, skewing your income figures.
No accounts receivable or accounts payable: not recording the actual dates when invoices were sent or purchases were made can create problems — especially when your invoices are paid late or your business racks up significant unpaid bills.
Limits your ability to scale: cash basis accounting does not conform to the Generally Accepted Accounting Principles (GAAP), the standard accounting framework for businesses in the United States. If your company exceeds $25m in sales per year, the IRS does not allow you to use cash basis accounting. So, if you want to scale your business, cash basis accounting probably isn’t the best way to go.
Who uses cash basis accounting?
Sole proprietors and small businesses who do not carry an inventory of stock may find that cash basis accounting does everything they need it to while being simple to understand and manage.
What is accrual basis accounting?
While cash basis accounting recognizes invoices as paid and bills as expenditure when the money changes hands, accrual basis recognizes them when invoices are sent and bills are received.
Going back to our earlier example, if you invoice a client in December, but they pay in January, accrual basis accounting would allow you to record revenue in December — when you sent the invoice and had earned the revenue.
Accrual basis accounting is not concerned with when cash is actually exchanged. Instead, it focuses on the overall company performance and position from month to month.
Pros and cons of accrual basis accounting
As with cash basis accounting, accrual basis has its own advantages which lend themselves well to certain types of businesses:
In line with GAAP: accrual basis accounting conforms to the Generally Accepted Accounting Principles in the USA.
More accurate: in terms of both business performance and financial health, following an accrual basis accounting approach is much more accurate than a cash basis one. This is because, by tying revenue and expenses to the exact date they were incurred, you get a clearer picture of your business’ performance each month.
Make better business decisions: having a clearer picture of business performance allows you to spot opportunities and risks more efficiently. Here’s a quick example of how this works:
You invoice for $20,000 worth of work in March and incur $5,000 in expenses, so your gross profit is $15,000. If your business usually only makes around $8,000 gross profit, then March is a great month for you, and you can start looking for ways to replicate this success across other months.
If you used cash basis accounting and all of these invoices and bills fell into April, you would mistakenly think that April was a great month — and start to look for opportunities in the wrong place.
Attract funding: investors appreciate an accurate financial overview, and accrual basis accounting allows you to present correct data on the long-term performance of your business.
Does not consider cash flow: because accrual basis accounting is not concerned with when invoices or bills get paid, it does not give you an accurate view of your cash flow. This means you have to track this metric separately.
Resource heavy: carrying out proper accrual basis accounting while also tracking cash flow requires the attention of a dedicated professional (whether that is an in-house team or a professional accounting firm).
Tax implications: depending on how invoices and payments fall, you may have to pay tax on income that you have not realized yet.
Who uses accrual basis accounting?
The IRS mandates businesses with upwards of $25m annual revenue to use accrual basis accounting. Also, any company that holds stock which they sell directly to customers would generally use accrual basis accounting.
Cash basis vs. accrual basis: what you need to consider
Now that you have a clearer idea of the differences between cash and accrual accounting, here are some questions to consider when deciding the right approach for your business:
What do you want your business to achieve in the next five years?
If you plan to sell large volumes of stock to customers and scale past $25m in annual revenue, you should follow the accrual method.
Note: the IRS does not allow you to change your accounting method during a tax year, so you must wait until year-end to request a change.
Who are the users of your financial information?
If your financial information is only used by you, cash basis accounting is sufficient. However, if you have a board of directors or want to attract investment, an accrual basis will serve you better.
Is your company required to use the accrual method for tax purposes?
If so, your decision has already been made for you. More information on accounting methods can be found on the IRS website.
If you need further guidance on deciding the best accounting approach for your business, MBS Accountancy can help. Contact us today to find out more!