What is Cash-Basis Accounting?
The job of business accounting is to measure, process, and communicate financial records. As simple as that might sound, there’s considerable nuance in how records are kept from company to company. Cash-basis accounting is one of the major methods. The other big one is accrual-basis accounting, which is also important to know.
To help you navigate these methods, this article will walk through how to use both methods and how they might benefit you. Then, we’ll compare and contrast the methods so you can choose the one that’s right for your business.
How to Use Cash-Basis Accounting
Perhaps the best part of the cash-basis accounting method is how easy it is to use. As explained earlier, with this method you only record transactions when cash is exchanged.
To master cash basis accounting, all you really need is a checkbook. When you pay a vendor, record the expense, and when your customer pays you, record the revenue.
If you’re recording transactions with a checkbook, you’re likely already using this method without even knowing it. Of course, you can also use the cash-basis method with accounting software such as Quickbooks or Freshbooks.
The Benefits of Cash-Basis Accounting
As you can see, cash-basis accounting is simple and easy. As a small business owner with limited time and expertise to worry about your books, that’s a major advantage.
Additionally, since it only deals with concrete funds, the cash method enables you to monitor your cash flow more easily. Finally, in some cases, cash-basis accounting can also help you save on your taxes because it enables your business to time expenses and revenue.
What is Accrual-Basis Accounting?
Accrual accounting is another accounting method that recognizes transactions when they occur, regardless of when payment is rendered. Accrual accounting is the dominant method except among very small businesses and sole proprietors.
One of the main reasons accrual accounting is dominant is because it’s the required method for most companies. The IRS requires businesses to use the accrual method if their average annual gross receipts for the preceding three tax years are greater than $25 million.
The Benefits of Accrual-Basis Accounting
Accrual accounting provides effective insight into your company’s long-term financial health. This is because it smooths out the variability caused by slow or late payments. Plus, it gives you a more precise view of the money that is coming in or going out in the future.
As mentioned earlier, it’s also the required accounting method for large companies. So, if you start with accrual accounting, you don’t have to worry about changing to different method later.
Accrual vs. Cash-Basis Accounting
The key functional difference between cash and accrual accounting is timing. Accrual accounting disregards the timing of payment while cash accounting is based on when payment is made.
When you pull financial reports, this makes a big difference in what you see in your records.
For example, let’s assume you’re using cash accounting, you have a 30-day payment cycle, and you pull a profit and loss report for October. Let’s say you invoiced $50,000 in October for which you received payment in November. Let’s also say your customers paid all your September invoices early, before the month of September ended.
In other words, you didn’t receive any payments in October, but you did invoice $50,000. In this case, your profit and loss report for October would show sales of zero.
As you can see, that’s not really indicative of how your company performed in October. Keep in mind, this same discrepancy will occur with expenses. So while you might be incurring a lot of expenses in a given month, cash accounting doesn’t show those expenses until you actually pay.
In the same example above, with accrual accounting, you’d see sales of $50,000. In this way, accrual accounting smooths out the variability caused by payment cycles. This gives you better insight into long-term financial performance.
Which Method is Right for Your Business?
The only true advantages of cash over accrual accounting is its simplicity and potential tax benefits. So if you’re resource-strapped and still trying to get your business off the ground, cash accounting could be the way to go. Even with that said though, you’ll need to switch to accrual accounting at some point.
Also, cash accounting limits the usefulness of your financial statements. So if you do use the cash method, you’ll have to keep in mind its limitations to avoid being misled by your financial reports.
The good news is, while it might seem intimidating at first, account software makes accrual accounting fairly simple. You’ll just need to get comfortable with a few accounting principles.
In short, if you can afford to spend at least $25 to $50 per month on software, you can make accrual accounting work for you.
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