Your profit depends on the type of accounting you opt for, and taxes depend on profit reports. It could be any cash basis accounting or accrual accounting. This kind of accounting directly impacts your loan credibility or raises investment capabilities.
Difference between Cash Basis Accounting and Accrual Basis Accounting
The variance between cash-based accounting and accrual accounting sprawls when sales and purchases are logged in your financial statements. Cash accounting identifies income and expenditure only when transactions are in monetary terms. Contrarily, accrual accounting identifies income when it’s earned and cost when it is billed even if it’s not paid.
It’s best to decide on which accounting type is ideal for you and stick to it. Switching between both methods can cause a problem in the long term; evade the hassle, choose one, and continue working with it every year.
1. Cash Accounting
The cash basis accounting identifies the income when money is received and expenses when they are settled. This method of accounting does not classify accounts payable or receivable.
A lot of small businesses choose to work with cash basis accounting because it is simpler to maintain. It’s convenient to keep track of when the transaction took place or, in other words, when the accounts were debited or credited. Cash accounting allows keeping the books straight as it eliminates receivables and payable accounts.
Moreover, cash methods are beneficial to keep a proper record of the cash business at the current periods. By looking at your bank account balance, you understand the exact funds at your disposal. Since transactions are not recorded until the money exchange doesn’t occur, the business revenue is not taxed unless it’s in a bank account.
2. Accrual Accounting
Accrual basis accounting recognizes when the income and expenditures are earned or billed and not received or paid. Usually, the revenue is recorded before any money changes hand, and the same happens for the expenses; they are recorded at the time of bill and not when it’s paid. This method of accounting is most commonly used than the cash basis of accounting.
For example, you record income at the time of project completion, regardless of when the payment comes in.
Accrual accounting gives a more pragmatic approach to record income and expense over time, hence implementing a long-term idea of the business that cash-based accounting falls short of providing.
On its other side, this method of accounting does not render any proper cash flow forecasting. A business can seem profitable, whereas it has a negative bank account balance. Without proper monitoring of cash flow, accrual accounting can result in disastrous outcomes.
- Accrual basis accounting recognizes revenue and expenses at the time of their occurrence, whereas cash basis accounting is not documented unless a cash transaction does not occur.
- Cash accounting is comparatively easier than accrual accounting though accrual accounting gives an accurate picture of a business’s financial health.
- Public-traded companies most commonly use the accrual accounting method as it mitigates revenue over time.
Need to Record Transactions?
Each business must keep proper track of all its financial transactions in books, mainly known as bookkeeping.
- It needs to be done if you want to stay well aware of your taxation.
- Your recorded financial reports have to be proper to file tax returns at the year-end.
Either you can do your bookkeeping or outsource a bookkeeping expert who can do it for you.
Comparison: Cash Basic Accounting vs. Accrual Basis Accounting
|Cash Basis Accounting||Accrual Basis Accounting|
|Identifies income when cash exchanges hand||Identifies income when it is earned|
|Identifies expenditure when cash is spent||Identifies expenditure when they are billed|
|No taxes paid on the cash that has not received yet||Taxes paid on accounts receivable and accounts payable.|
|Accounts for cash paid or received, which leads to easy tracking of the company’s cash flow.||It includes accounts receivable and accounts payable, giving the accurate status of the companies profitability.|
|Generally used by small business enterprises who have no inventory.||They are generally used by medium and large business enterprises that have revenue of more than $25 million.|
Cash Basis Accounting vs. Accrual Basis Accounting: The Effects
Knowing the difference between both accounting methods accounting is crucial; however, it is important to put this into consideration by acknowledging its direct effect on both methods.
Let us assume that, you practice the transaction mentioned below in a month:
- Sent an invoice for $6,000 for a web project which is finished this month.
- Bill of $2,000 received for the fees of developer for the work assigned
- A bill of $100 in fees paid which you received last month
- $2,000 received from a client for a web project that was invoiced the previous month
The Effect – CASH FLOW
Practicing the cash basis accounting method, the month’s profit would be $2,000 (INCOME) minus $100 (FEES) which is $1,900.
Although on the other hand, by accrual basis accounting method, the month’s profit would be $6,000 (INCOME) minus $2,000 (DEVELOPER’S FEES) which is $4,000.
This scenario showcases how the look of income stream and cash flow can be affected by the type of accounting method used.
The Effect – TAXES
Let us assume that the scenario mentioned above took place between October and November of 2019. One of the variability between cash accounting and accrual accounting is that they affect the tax year in which income and expenses are reported.
When practicing cash basis accounting, income is recorded at the time of receiving it, whereas, in accrual accounting, income is recorded at the time it is earned. Keeping in mind the above scenario, by the accrual method, you will record the transaction of $6,000 in November 2019 under the income statement even if you receive that amount in 2020, and pay taxes on it.
Do small businesses use cash basis accounting or accrual basis accounting?
If your company’s average income is more than $25 million over the last three years, you are obligated to use accrual basis accounting according to the IRS. In case your business does not reach those criteria, you are free to use cash accounting.
Cash accounting is suitable for small businesses which do not have any inventory. If you are dealing with inventories. It is best to use accrual accounting.
In case you are looking to switch from cash to accrual accounting, file Form 3115 to get approval from IRS.
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Both the methods, be it cash accounting or accrual accounting, come with their own pros and cons, and each only showcases some part of your company’s financial status. Companies generally use the accrual method, specifically publicly-traded companies. And the reason behind all the businesses shifting to accrual basis accounting is that it smoothens out the earnings over time; it accounts for income and expenses because they are generated rather than recorded like cash accounting. Knowing both the accounting method and cash flow of the company is vital while making an accounting decision.