Anyone running a business needs to implement good accounting processes. This is important for compliance reasons and to gain a snapshot of the company’s current financial health.
Established accounting methods are core to defining an organization’s direction and uncovering needed improvements.
Let’s examine cash vs. accrual and which method your company should be using.
Cash accounting is the most common form of accounting. It’s also the simplest form of accounting because transactions are entered only when cash changes hands.
Income is recorded when received, and expenses are recorded when paid. Accounts receivable and accounts payable are not included in cash accounting.
For example, if you received an order for $100,000 in May but the invoice remains unpaid until July, the income is recorded as July income. Expenses work the same way.
Generally, due to the lack of accounts receivable and accounts payable, this is not a suitable accounting method for larger, established brands.
Accrual accounting is the preferred accounting method for bigger organizations. It’s a far more accurate business income accounting method because it includes accounts receivable and accounts payable.
The difference between cash and accrual-based accounting is apparent under the accrual model; payments and expenses are recorded immediately rather than when money changes hands.
For example, if you spent $500,000 on new machinery in September, but the payment wasn’t sent until November, it would still be recorded as a September expense.
Under the Generally Accepted Accounting Principles (GAAP), the accrual method is stipulated as best practice for financial reporting.
For large corporations, CEOs have no choice in the matter as they are legally required to use accrual accounting.
The difference between cash and accrual is when incoming payments and outgoing expenses are recorded. This is the only practical difference in cash basis vs. accrual basis accounting.
However, the impacts of using one accounting method over the other are wide-ranging. The major differences can be summed up like this:
There are pros and cons to each type of accounting. Before choosing the proper accounting method for you, it’s important to weigh the advantages and disadvantages of each one.
To the uninitiated, accrual accounting vs. cash accounting may seem pretty similar. In terms of the bottom line, however, the accounting methods can have radically different outcomes on the financial health of a business.
Here’s an example of how cash or accrual can impact your bottom line:
Company A issues a July invoice for $50,000 after building an app for a client. They have also received a bill of $10,000 for contractor fees. A previous bill of $1,000 was paid for a bill received in June, and Company A also received $10,000 from a small project, which was also invoiced in June.
Let’s take a look at how accrual accounting vs. cash accounting alters the financial health of the business.
When using the cash basis, the profit for July is $9,000 because Company A received $10,000 and paid a bill of $1,000. However, under the accrual basis accounting method, the profit is $40,000 because the bill paid and the income received would have been accounted for in June’s numbers.
As you can see, there’s a massive difference in a July profit of $9,000 vs. $40,000.
Taxes are also a factor when using a specific accounting method. For example, cash vs. accrual will impact exactly how much tax you pay.
For example, if you issue an invoice for $100,000 in December and the invoice is paid in February, the $100,000 would be counted against the previous tax year under the accrual system. Cash basis accounting, on the other hand, would add that $100,000 in the new year, because that was when the money was received.
When businesses choose their accounting method, it’s important to choose the one that works for the business. Accounting is a valuable tool for understanding your company’s financial health and plays a significant role in making future decisions.
While cash basis accounting does have its advantages and is well-suited for microbusinesses or businesses with no inventory, the vast majority of growing companies should invest in implementing the accrual method.
It’s a more resource-intensive form of accounting, but when executed correctly, it pays dividends.
Accrual accounting may be intimidating, but that’s no excuse for sticking with the more straightforward cash-basis accounting method.
Here are some of the reasons why you should switch now.
For an overall look at a company’s financial health, accrual basis accounting allows business owners to get the full story immediately.
This method enables you to see where the profit is coming from, where the expenses are going and also helps to match revenues with expenses.
An intelligent POS device can help paint this financial picture. But, generally speaking, it’s a level of detail cash basis accounting fails to offer.
Legally, if your business reports more than $5 million in annual sales or $1 million in annual inventory sales, you must use the accrual accounting method for financial reports and for preparing income taxes.
If you run a growing business, you have no choice over which accounting method to use once you hit this threshold.
It’s much easier to make the switch earlier to prevent disruption and confusion later.
Using this accounting method, you gain a more accurate view of the company’s resources and liabilities. For companies, this allows them to manage cash flow better and plan for the future.
It’s much easier to assess incomings and outgoings when utilizing accrual basis accounting.
The big downside of using cash accounting is incomings and outgoings are logged when they happen, rather than when invoices are issued. Accrual manages your finances in real-time.
Business managers can better plan for the future when they have a real-time picture of the company’s financial health.
Companies can easily track where their profits are and prepare for any financial plateaus before they happen.
Anyone who has ever built a business understands the value of credit. For organizations to survive and expand, they must secure credit of some kind.
The accrual method could be the difference between getting approved for credit and suffering from cash flow issues.
For example, if a business received $0 in August and paid a bill of $10,000 issued in July, an investor would see that their monthly profit/loss for August is a loss of $10,000. This is under the cash basis method.
Under the accrual basis, an investor might see that the business also billed a client for $100,000 to be paid in September.
Instead of a $10,000 loss, the $10,000 bill would have been included in July’s figures, and the $100,000 invoice would be counted as profit in August because that was when it was issued.
So, from -$10,000 reported in August, the company has now declared a $100,000 profit for August using the accrual method.
It’s an extreme example, but this is the difference it can make when dealing with large figures.
Finally, you may have heard about an alternative to both cash-basis and accrual-basis accounting. The third option is known as “hybrid method accounting.”
Using hybrid accounting, you can use a combination of cash, accrual, or other special accounting methods. The IRS does permit this, but calculations must be accurate and consistent.
The IRS bans the use of the hybrid method if your business uses the cash basis for reporting income and the accrual model for reporting expenses.
Like with most things accounting, there are exceptions to every rule.
For the vast majority of businesses, it’s best to stick to one or the other rather than adopting the hybrid method.
When it comes to cash vs. accrual accounting, the latter should be used by most businesses.
While cash-basis accounting is perfectly acceptable when starting, it quickly becomes unsuitable for growing businesses. If you’ve already crossed the thresholds described above, your organization may have no choice but to switch to the accrual method.
Part of creating accurate accounts under any method is solid internal communication. A modern POS system is key to making that happen.