As a small business owner, itβs important to understand the difference between the two main methods of accounting: cash and accrual. Even if you donβt handle your own financial reporting, itβs vital to know how each one works so you can choose the best bookkeeping practices for your business.
Letβs take a look at the differences and respective implications of each accounting method.
What Is the Cash Method?
With the cash basis of accounting, you record income as itβs received and expenses as theyβre paid. This does not take into account any accounts receivable or payable, as it only applies to payments from clients when the cash is in hand, and expenses when the transaction clears your bank account.
For example, if you invoice a client for $1,000 on March 1 and receive payment on April 15, you would record the income in Aprilβs bookkeeping. This is when the money was received and in hand.
Many small business owners choose the cash method of accounting because itβs a simplified bookkeeping process. Itβs easy to track money as it moves in and out of your bank account because thereβs no need to record receivables or payables.
Additionally, your small business doesnβt have to pay income tax on any revenue until the moment itβs deposited into your bank account.
One downside to using the cash basis of accounting is that it can produce an inaccurate overall picture of your finances. Since it doesnβt account for all incoming revenue or outgoing expenses, it can lead you to believe youβre having a very high cash-flow month, when in actuality this is a result of last monthβs work.
Itβs important to note that this method does not take into account any accounts receivable or accounts payable. This is because it only applies to payments from clientsβin the form of cash, cheques, credit card receipts, or gross receiptsβwhen payment is received.
Who uses cash basis accounting?Β
Because of its simplicity, many small businesses and sole proprietors use the cash basis method as their primary method of accounting. If your business makes less than $25 million in annual sales and does not sell merchandise directly to consumers, the cash basis method might be the best choice for you.Β
Some of the benefits include:
- Shorter learning curve
- Fewer items to record
- Easier tracking of expenses and revenue
Example of cash basis accountingΒ
Using the earlier example where you invoice a client for $1,000 on March 1 and receive payment on April 15, you would record the income as received for the month of April, since thatβs when you actually had the money in hand. So the breakdown looks like this:
- The invoice is sent for $1,000 in March
- You do nothing in MarchΒ
- You receive payment in April
- You record the income in April
What Is Accrual Accounting?
The accrual basis of accounting is basically the complete opposite of the cash method. Income and expenses are recorded when theyβre billed and earned, regardless of when the money is actually received. It is worth noting that accounting standards outlined by the international financial reporting standards (IFRS) stipulate the use of accrual accounting for financial reporting, as it provides a clearer picture of a companyβs overall finances.
Using the example from above, and applying the accrual basis of accounting, you would record the $1,000 as income in Marchβs bookkeeping versus in April when you actually received the funds.
The upside to using the accrual method is it gives small business owners a more realistic idea of income and expenses during a certain period of time. This can provide you (and your accountant) with a better overall picture of how your business is doing and where itβs headed in the future.
One drawback to the accrual method is that it doesnβt account for cash flow or funds that are available in your bank account. If you donβt have careful bookkeeping practices, the accrual-based accounting method could be financially devastating for a small business owner, as your books could represent a large amount of revenue while your bank account is completely empty.
Who uses accrual accounting?Β
Under IFRS it is expected that businesses use the accrual method of accounting. However, in the US which primarily uses GAAP regulations, only businesses that are either publicly traded or produce over $25 million in sales revenue over a three-year period are required to use the accrual method.Β
Example of accrual accountingΒ
Using the example from above, if a small business bills a client $1,000 on March 1, you would record that $1,000 as income in Marchβs bookkeepingβeven if the funds didnβt clear your account until April 15.
- The invoice is sent for $1,000 in March
- You record revenue in March
The same holds true for accrued expenses. In this case, if your small stationery business buys paper supplies on a credit card in June, but doesnβt actually pay that bill until July, you would still record that as a June expense. Letβs break this down:
- You bought paper supplies in June
- You record the expense in June