Cash vs. Accrual Accounting: Which accounting method is best for your business?
November 5, 2021 •ROARK
Today, let’s talk about cash vs. accrual accounting, which accounting method is best for your business. Business owners have long complained about the difficulties of producing complex financial reports. There are two types of accounting systems available. And the question is, what method of accounting do you use?
What is cash basis accounting?
Cash-basis accounting is the method of doing your accounting based on cash in and out. It’s known as the checkbook method of accounting, in short. Every time you receive money, it’s recorded as revenue. An expense is any time money is spent to pay for something.
Cash-basis accounting example
You may, for example, spend money on insurance and acquire a year’s worth of insurance coverage. In other words, when your check is cashed, and you spend money on something, it’s considered an expenditure for the cash-based accounting system.
What is accrual accounting?
In the case of a cash basis, income is recorded as it becomes available. In contrast, the accrual-based approach is very different. Rather than recording the income and expenditure, accrual-based accounting aims to quantify income and spending when incurred instead of when cash comes in, and money goes out.
Accrual accounting example
Let’s revisit the same example as before with insurance. What if you make a $100,000 payment for 12 months worth of insurance coverage? Rather than recognizing it all as a $100,000 expense during the month that you write the check, what you do is make an accrual. In accrual accounting, you recognize the expense over 12 months or $8,333.33 per month. That is the accrual method. That’s quite a difference.
Cash Basis Accounting: The advantages and disadvantages
First and foremost, a cash-based approach is simple. It’s really easy to go through. Income comes in while expenditures are paid out. It’s not complicated to discover the information you need.
Accrual accounting necessitates the making of numerous estimations and adjustments at the conclusion of the period. It’s simple when you use cash basis accounting. Cash went in, and cash came out; you can see it on your bank statements, and your financial reports are based on that. That is why many company owners, particularly those who are smaller, prefer cash-based accounting.
Cash-basis accounting is also helpful since it minimizes the chance of errors and mistakes. As long as you’re getting that large bank reconciliation done and correctly, it should be correct. There shouldn’t be errors.
Then, in addition, if you look at it, the cash basis is more flexible. To run, it requires fewer resources from the accounting department. So you don’t need as much sophistication. You save time. You may get the information there a lot faster.
From a taxation standpoint, it’s especially advantageous. If you see a lot of income, and you’re doing your tax planning with your CPA at the end of the year, you go, oh no, we’re making too much money. You write many checks before the year-end. It’s a typical tax planning strategy. So you can offset the income with your expenditures. It also helps to reduce tax liability or, at the very least, defer payment for a year. That’s nice. There’s much flexibility to it. It’s simple and easy to use.
Accrual Accounting: The advantages and disadvantages
Let’s discuss accrual-basis financial statements. The first and most important thing about accrual basis accounting is that they are more accurate since you’re matching the income and costs of the period they incurred
So I was sitting down with one business owner, and we were looking over their financial statements. And they’re like, January did well. February did well. March did well. We get to April, and April had a loss. So we got down to the bottom of that, and we’re like, “Why are we showing a loss? What’s new? or What’s different?”
The difference was in April when we compared labor costs while they were on a biweekly payroll. Due to their cash method, they had three pay periods in April. However, because everything went out, they recognized the cost at that moment. If they were on an accrual basis, they would have had more previous expenditure and less expense in April
Accrual accounting confuses many people. It’s also a lot more difficult to truly comprehend and interpret your financials since you’re trying to account for all these slight differences that occur.
So, when you’re making projections on an accrual-based financial statement, it’s easier to focus on that. Then you may convert it into cash-based when you see where the trends are going. What if you’re on a cash basis? These time gaps and other factors make prediction more difficult.
One of the most challenging aspects of accrual basis accounting is that they are a little more complicated to explain because we’re making all these changes and if you’re an accountant, great. The accountants all understand accrual-based financial statements. When we get to non-accountants, though, trying to explain how changes, estimations, and other factors combine with the period to match the cost with the time becomes difficult.
However, when you report to external parties, get capital from banks, or try to sell your business, Generally Accepted Accounting Principles (GAAP) based financial statements are based on accrual-based financial statements. When it comes to working with other parties, the usual language is accrual basis accounting; since then, all these time variances emerge, and there’s a foundation that everyone understands and can compare. So, whenever you’re putting accrual-based financials into your budgets, they’ll be able to match the budget to the accurate data or actuals.
How to choose between cash vs. accrual accounting?
There are several considerations when choosing between using cash vs. accrual accounting.
Internal vs. External Reporting
The first thing to think about is whether you need internal or external reporting. Internal reporting, in contrast to external reporting, may influence the accounting method that you choose. So, if you’re looking at cash management, cash-based financials are quite simple since you already have a basis for the cash flow.
However, if you’re going to your bank, attempting to perform an audit, or undertake an M&A transaction, accrual-based financial statements will be required.
Growth and Expansion Plans
What are your growth and expansion plans? That’s going to be the next question. If you’re a small firm on cash-basis accounting right now and want to expand and get capital, you’ll need to switch to accrual-based financial reports.
Industry and Business Type Considerations
Then the question is: depending on your industry, does the need to use cash vs. accrual accounting vary? The short answer is yes. If your sector is cash-based, and I’ll give you an example of the hospitality business or retail, you’re collecting cash now.
Having inventory affects the need as well. At some point after the small business exemption, the IRS will demand accrual-based financial reports from you, especially if you have inventory. So it’ll be based on the size of your firm and where you’re at in revenue. Inventory is a typical characteristic of businesses, such as C corporations, retail, or manufacturing industries.
And so those are going to cause differences between cash basis and accrual accounting. So, if you’re ready to convert from cash to accrual but need assistance, we’d be delighted to assist. We also understand that there’s a lot of confusion and uncertainty with cash vs. accrual accounting. Give us a call if you’d like assistance. We’d be delighted to assist you.