When you own a business, it’s common to choose between popular accounting methods, including cash basis and accrual. Under the cash basis accounting method, you account for sales and expenses when you actually receive or spend the money. In contrast, with accrual accounting, you count everything when you make the deal.
Example of Cash Basis Accounting
To illustrate how these two accounting methods work, imagine you run a manufacturing plant. You agree to produce 100 items for a client, and the client agrees to pay you Rs. 60,000 upon receipt of the goods. If you use accrual-basis accounting, you note that amount in your accounting records as soon as you finalize the deal. If you use cash-basis accounting, you don’t note the funds until you have the money in your hands.
To flip the example around, imagine you’re the buyer in the above situation. With the accrual method, you note the Rs. 60,000 expense as soon as you agree to buy the items. If you use the cash-basis method, you don’t note the transaction until you receive the items and make the payment.
Benefits of Cash-Basis Accounting
The main benefit of cash-basis accounting is that it’s simpler. You note transactions in real time as they happen. You don’t have to worry about adjusting your books if a deal falls through or a customer never pays. Your accounting records also faithfully represent how much cash your business has available, which can make it easier to determine if you can afford certain purchases.
Disadvantages of Cash-Basis Accounting
Although the cash method can provide a more accurate view of your cash flow, accrual basis accounting gives you a clearer picture of your company’s overall profitability. To return to the above example, imagine you are selling the items and you record the Rs. 60,000 as soon as you make the deal. As you buy materials, pay wages to your factory workers, and incur other expenses, you note those amounts in your records. As those expenses get subtracted from the Rs. 60,000, you continue to see a positive number on the bottom line of your balance sheet.
In contrast, if you used the cash method, you incur all those expenses before you note your sale. As a result, it looks as if your business is losing money. Because of this, most medium and large businesses use the accrual basis, as do most governments around the world.
As you decide whether cash or accrual basis is right for your situation, you may want to consider government regulations. In some cases, your business may be required to use the accrual basis. In other situations, you may be required to use the cash basis. For instance, when the goods-and-services tax (GST) first launched, the government accepted both accrual and cash-basis GST returns. As of April 2018, though, the Finance Minister announced that all GST returns should be prepared using cash-basis accounting. This means that you only report and pay GST on sales for which you have already received payment. Prior to this announcement, the government was accepting GST payments for sales that had been invoiced, even if the business hadn’t received the payment yet. That required businesses to request refunds when their clients refused to pay, and it led to more paperwork for the government.
Whether you decide to use accrual or cash-basis accounting, you need the right tools. Cloud-based accounting software such as QuickBooks lets you choose your accounting method, and it simplifies the process to make accounting as easy as possible for you.