Building a business involves understanding how cash flows in and out. Your financial statements are key to that process, but to make sure your financial statements can allow for accurate comparisons across time, you need to have a consistent form of accounting in place. With that in mind, let’s talk about what types of accounting methods are available and how to determine which one works best for your company.
What is Accrual Basis Accounting?
Accrual accounting is an accounting method of recording revenue and expenses when they are earned or incurred, regardless of when the cash is received or paid. This method allows a company to match its revenues and expenses in the same period, thus reflecting its true financial position, even if the cash flow is delayed.
This is the preferred method by GAAP and IFRS, plus it is required for companies with average revenues of $25 million or more over three years.
Here are a few examples of accrual basis accounting:
- Accounts receivable – The revenue a company has earned by providing goods or services to a customer but has not yet received payment for. You would record the revenue as an accrual in the income statement and an asset in the balance sheet.
- Accounts payable – The expense a company incurs by purchasing goods or services from a supplier but which has not yet been paid for. You would record the expense as an accrual in the income statement and a liability in the balance sheet.
- Accrued interest – The interest a company earns or is owed on a loan or investment, which has not yet been received or paid. You would record the interest as an accrual in the income statement and an asset or liability on the balance sheet.
Accruals are created by adjusting journal entries at the end of each accounting period. This method allows the current and future cash inflows and outflows to be combined to create an accurate picture of your company’s current and long-term finances.
Essentially, accrual accounting uses a double-entry accounting method, where payments and receipts are recorded in two accounts when the transaction is initiated, not when they are made. This provides immediate feedback on expected cash inflows and outflows, making it easier for businesses to manage their current resources and strategize for the future.
When to Use Accrual Basis Accounting
You should use accrual basis accounting in the following situations:
- For any regulatory filing requiring GAAP
- When accepting or making credit card payments
- To track assets and liabilities
- If a company has complex transactions
- To account for sales returns, bad debts, or reduced product value by ensuring reserve money is set aside to cover these costs.
A few exceptions do exist, largely around income taxes. Small businesses with less than $25 million in annual revenue do have the option to choose to use either cash or accrual basis accounting.
Sole proprietors, partnerships, and S-Corps are allowed to use cash accounting. If you change your accounting method, that means following additional filing requirements with the IRS.
Pros and Cons of Accrual Basis Accounting
There are several advantages of accrual basis accounting, including the following:
- More accurate financial statements – By matching expenses with revenues, accrual based accounting provides an accurate representation of your company’s financial health and performance.
- Better business analysis – This method allows you to conduct more useful business analysis.
- Easier planning – With this method, you can account for all your expenses and revenue within the right period, allowing you to create budgets for your expenses and predict sales, which plays a role in determining inventories, staffing, and other areas of operation.
- GAAP compliance – This allows for the creation of financial statements that are unaffected by cash timing in business negotiations. Thus, periodic financial statements are more representative of your company’s financial health.
However, for every advantage, there are also some disadvantages or cons, which can include the following:
- Difficulty – The rules of recognition of revenue and expenses can be complicated, which can result in needing an accountant or bookkeeper to assist you.
- Deception – Confusion with this accounting practice can lead people to deception of financial statements. Some businesses have used this method to hide weaknesses and mistakes within their financial reports, thus committing fraud.
- Difficult to switch costs – If you have started with one accounting method, it can be difficult to switch to the accrual method, especially if you are having difficulties with cash flow.
With all this in mind, let’s dive into what cash basis accounting is and how it differs from the accrual method.
What is Cash Basis Accounting?
Under this method, revenue is reported on the income statement only when it is received. Expenses are recorded only when they are paid. It can be used for both small businesses and personal finances. The key advantage is that this method is simple, reflecting the flow of cash when it is actually paid or received.
However, it can also tend to overstate the financial health of a company that is cash-rich because you aren’t recording the accounts payable (expenses) that might exceed your current cash on the books and your revenue stream. Therefore, an investor might think that your business is profitable when it is actually struggling financially.
When to Use Cash Basis Accounting
Cash basis accounting is generally the simplest accounting method and is preferred by self-employed professionals and small business owners. It can also be adequate for government agencies, non-profit organizations, community associations, and small service businesses that do not deal in inventory or sell and buy on credit.
If you have a few transactions per day, have a small number of employees, do not publish financial statements for auditing purposes, do not deal with inventory, or do not sell or buy on credit, then cash basis might be the right method for your business.
Pros and Cons of Cash Basis Accounting
The advantages of cash basis accounting are the simplicity of the method and its ability to work well for small businesses and those companies that are in the early stages of development, where knowing the amount of cash you have available is critical.
However, cash basis also has disadvantages, particularly the fact that a company’s performance can appear to fluctuate more under the cash basis than it does under accrual accounting.
The timing of income and expenses being recorded depends on when companies and customers pay their bills. Additionally, the expenses and revenue will not necessarily match up in the same accounting period, thus presenting a misleading picture of your company’s performance.
Accrual vs Cash Accounting Example
Assume your company sells machinery. If you sell $5,000 worth of machinery using the cash method, you won’t record the transaction until you receive the $5,000 in payment. In the accrual method, you would record the $5,000 as revenue immediately upon completion of the sale, even if you haven’t received the money yet.
The same is true of your expenses. If you receive a $1,000 power bill under the cash method, you won’t record that expense until you actually pay the bill. In the accrual method, that $1,000 is recorded the day you receive the bill.
Clearly, these are some simple examples, but they illustrate how you can manage your finances as a business owner. But how can you decide which is the right option for your business?
Which Works Better for Your Business?
Defining the best method for your business will depend on several different factors. Additionally, if you intend to take your business public or otherwise grow your business, then it is likely that the decision is made for you. Most cash-only businesses will opt for the cash method, since they will not have credit-related liabilities.
The Complexity of Your Business
If you have inventory, multiple daily transactions, and a number of expenses daily or weekly, then your business and its complexity likely is going to determine that you should follow the accrual method.
However, simple businesses, freelancers, and sole proprietorships likely will not have the number of transactions and complexity, so it makes the cash basis more appealing and a better alignment.
Sales Revenue
Lower sales revenue likely means the cash basis will be easier to manage your finances. On the other hand, hirer sales revenue will likely trigger requirements from the IRS that mean you need to follow the accrual method instead.
Publicly Traded
When your company is publicly traded, you need to follow specific rules in the production of your financial statements since they have to be audited and must follow the GAAP. As a result, your company would be required to follow the accrual method to meet those requirements.
Accounting Software Solutions for Accrual and Cash
There are plenty of options for maintaining your financial records, including accounting software. Quickbooks, for instance, offers multiple versions of its software, thus allowing you to use cash or accrual methods for accounting. Working with your bookkeeper, you can set up your chart of accounts, making it easier to transition into the accrual method.
Best Practices for Implementing Accrual or Cash Accounting
Regardless of the accounting method you use, there are several best practices that you should implement to maintain accurate and updated financial records. These best practices include:
- Preparing an annual budget
- Doing a monthly review of results against your budget
- Preparing a budget forecast
- Following a close checklist and calendar
- Verifying expenses and revenue
- Reviewing payables and receivables aging monthly
- Enforcing segregation of duties
- Reviewing reconciliations and financial statements
- Be consistent
- Consider outsourcing bookkeeping and accounting tasks
Frequently Asked Questions
Can I switch from cash to accrual (or vice versa) later on?
Yes, you can switch, but it can be complicated. Most businesses that start out using a cash method eventually switch to accrual, but the process takes time and should involve your bookkeeper and accountant.
Which accounting method is better for tax purposes?
For tax purposes, the accrual method is better, since it aligns with most of the requirements laid out by the IRS.
Is there a hybrid method that combines elements of both cash and accrual accounting?
Yes, a hybrid method exists where you do not record receivable incomes but record all payable expenses. This system is a mixed system of accounting, known as a hybrid. It can be used when your outside income is very low.
You need not show any outstanding income but show only outstanding expenses for more deductions, as well as decreasing your net profit, which impacts your tax liabilities. However, most larger companies would not be able to use this method since, under law, they would be required to use the accrual basis method.
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In Summary
Cash or accrual basis accounting methods are available to businesses as a means of managing their financial records. While each method has its own advantages and disadvantages, the truth is that accrual accounting is more common in both larger companies and those with higher levels of revenue. Working with your accountant or bookkeeper can help you to find the right fit for your business, both as it starts and expands, allowing you to create reliable financial records that can be audited and that also meet the IRS requirements.
