One of the most important decisions you’ll have to make as a business owner is which accounting system to use for record-keeping. The good news is that your choice is pretty straightforward – cash basis or accrual accounting.
A lot of small business owners choose the accrual method because it suits their specific needs better. But will it be the right option for you too? Perhaps, but it’s better to first understand how this system works.
What is Accrual Accounting
The simplest, most basic definition of accrual accounting is this: expenses and revenue are recorded as they occur, whether the expense has actually been paid for or the revenue has been received or not.
Thus, a report at month’s end will list every expense by date and amount and every sale made, by date and amount, and the ending balance will reflect those to elements. The ending balance will not reflect actual cash on hand, however. Because invoices that you’ve sent out may not have been paid yet, and if accrued expenses have occurred toward the end of the month for which an invoice has not yet been settled, you still don’t have that cash on hand.
The IRS Rules Regarding Accrual Accounting
Small businesses have the option of choosing either cash or accrual accounting if their revenues are under $5 million a year. The one exception is retail stores, that must use the accrual system if their revenues exceed $1 million, along with any other company whose revenues exceed $5 million.
Accrual Accounting Example
Here’s a quick sample calculation to give you a better idea of how this system works:
Date Expense Sales
10/2 $1,306.52 (ABC Supply)
10/3 $3,708.86 (Home Depot)
10/4 $2,456.72 (Customer A)
10/4 $3,286.46 (Customer B)
10/6 $5,207.58 (Customer C)
10/9 $2,710.23 (DEF Supply)
10/10 $4,723.16 (Customer D)
10/15 $2,620.00 (Salaries)
10/21 $4,912.72 (Customer E)
10/22 $ 756.86 (Lowes)
10/31 $2,620.00 (Salaries)
10/31 $ 373.92 (Soc. Security Contribution)
Totals $14,096.00 $20,568.64
Note: the Lowes bill has not yet been paid, and customers D and E have received their final billing statements but have 30 days to make payment. You have actually only received ½ of those customers’ payments. So, while this is not an actual picture of the cash you have on hand, the month of October did give you a profit of $6,472.63. It was a decent month.
Of course, you will still have that quarterly tax payment, but it is not listed here because it will not be paid until January 15 of next year. It will then be listed as an expense on the January monthly report.
Cash vs Accrual Accounting: Key Differences
The other standard option for your accounting system is that of a “cash basis.” Here is a quick summary of the differences between cash and accrual accounting:
- The example above provides a summary of sales and expenses. It does not reflect the actual amount of money that you have in your bank account as a result of your sales and expenses. What you receive with accrual accounting is a summary of sales and expenses that were “accrued” during that month.
- The cash accounting system, on the other hand, would only include those expenses that you had actually paid out during the month and the actual payments from your customers that came in. Anything that would be carried over into the next month would not be included in the report.
Given these two accounting systems, you might be asking yourself if one is better than the other for your purposes, and when accrual basis accounting makes more sense.
To make a more weighted decision, let’s take a look at the main pros and cons of accrual accounting.
The Pros of Accrual Accounting
The main drawback of cash basis accounting is that it can somewhat skew the view of your business finances and cash flow. Because under this system the inbound and outbound cash does not enter the records up till it has literally changed hands.
Thus, for example, if you use and extend credit to your suppliers, your accounting will not display that information, resulting in an incomplete picture. Accrual accounting addresses this shortcoming.
1. More Realistic Financial Picture
Some business owners believe that an accrual system is a better indicator of the financial health of their businesses. Take another look at the example above. Suppose those companies from which your purchased supplies/equipment extended you credit, even for as long as 90 days. And suppose that your customers all paid you upon completion of your jobs for them. Your month’s end “profit” would be much higher than the above example shows. And it would be pretty unrealistic since the bills have not been paid out.
2. Tax Advantages
Accrual accounting can also translate into a tax advantage during some quarters. Because you can list your expenses as they were incurred, even though you have not paid them out yet, you have a higher deduction than you would have under a cash system. Using cash, you can only deduct those expenses that you have actually paid out during a given quarter.
3. Better Forecasting
Because the accrual system shows a more realistic picture of your typical monthly income and expenses, no matter what your bank account might say, it is easier to get a picture of your overall financial health and to plan for your financial future. If your profit is not enough for your liking, for example, you can invest in additional marketing or find cheaper suppliers.
4. No “hills and valleys”
When you use a cash accounting method, your monthly reports can vary widely. If you haven’t paid suppliers and all customers have paid, you have a “hill” and may be tempted to spend profit that you don’t really have. On the other hand, if you have paid all of your expenses but customers have been slow to pay, you are in a “valley” and may lose some sleep at night.
These four pros are attractive of course. But lest you decide to jump to an accrual method today, you should also consider the cons of this system.
The Cons of Accrual Accounting
The accrual accounting system also comes with limited visibility. Just as cash accounting can show profits that aren’t there, so can an accrual system. It can provide an unrealistic picture of your financial health if you do not keep in mind the fact that some expenses have not yet been paid out.
The other cons of this approach are as follows:
1. More Challenging Cash Flow Planning
There are uncertainties related to cash flow. You cannot predict with good precision when customers will actually pay. You just have accounts receivable that you are counting as already “received” when, in fact, they are not. And if you have customers that do not pay, you incur the expense of collection for revenue you have already counted on your books. These things can impact your cash flow. Using a cash system lets you know exactly how much you actually have to work with.
2. Calculation Difficulties
An accrual accounting system requires rather vigorous and time-consuming bookkeeping – more than the simpler cash methods. And if inaccuracies occur, then the picture of revenue vs. expenses can be skewed. This can also impact business forecasting.
3. Higher Tax Bill
There can be a tax disadvantage too. If you have to include revenue that has not actually come in yet, your tax bill can be a bit higher in a given quarter.
Most small businesses begin with a cash accounting system, primarily because it is simpler and they like knowing exactly how much cash they have on hand at any given time. Owners tend to sleep better at night with a fully accurate account balance in their heads. But forecasting is a bit more difficult under this method. As a business grows and becomes more complex, it might be better to shift to the accrual method.
If, after looking at the pros and cons of the accrual method, you are still uncertain, sit down with an accountant who can look at your business through an objective eye and make the right recommendation for you!
Photo by Beatriz Pérez Moya