As a small business owner, it’s important to understand the difference between the two main methods of accounting: cash and accrual. Even if you don’t handle your own financial reporting, it’s vital to know how each one works so you can choose the best bookkeeping practices for your business.
Let’s 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 it’s received and expenses as they’re 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 April’s bookkeeping. This is when the money was received and in hand.
Many small business owners choose the cash method of accounting because it’s a simplified bookkeeping process. It’s easy to track money as it moves in and out of your bank account because there’s no need to record receivables or payables.
Additionally, your small business doesn’t have to pay income tax on any revenue until the moment it’s 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 doesn’t account for all incoming revenue or outgoing expenses, it can lead you to believe you’re having a very high cash-flow month, when in actuality this is a result of last month’s work.
It’s 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 clients—in the form of cash, cheques, credit card receipts, or gross receipts—when payment is received.
Who uses cash basis accounting?
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.
Some of the benefits include:
- Shorter learning curve
- Fewer items to record
- Easier tracking of expenses and revenue
Example of cash basis accounting
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 that’s 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 March
- 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 they’re 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 company’s overall finances.
Using the example from above, and applying the accrual basis of accounting, you would record the $1,000 as income in March’s 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 it’s headed in the future.
One drawback to the accrual method is that it doesn’t account for cash flow or funds that are available in your bank account. If you don’t 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?
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.
Example of accrual accounting
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 March’s bookkeeping—even if the funds didn’t 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 doesn’t actually pay that bill until July, you would still record that as a June expense. Let’s break this down:
- You bought paper supplies in June
- You record the expense in June