For a small business, accounting can often be more complicated than it has to be, and among the first choices you’ll have to make is the method you want to use for recording your income and expenses.Although the two methods are different, the fundamental concept is simple: in cash accounting, income and expenses are recorded when money actually changes hands; in accrual accounting, income is recorded when it is earned and expenses when they are incurred, even if the payment is made later.Well, then, which should you choose? This will vary according to the type of business you have, the way you run it, your requirements for reporting, and the tax rules that apply to you.
With cash basis accounting, you record income when you actually get the money and usually record expenses when you actually make the payments.For example, suppose you finish a project for a customer in December, which involves a payment of $2,000, but the customer makes the payment to you in January.Under the cash accounting method, you treat the $2,000 as income in January since that is the month in which you received the money.One reason the cash accounting method is attractive to small businesses is that it is rather simple and provides a clear picture of the money that has actually gone in and out of your bank account.
What is accrual basis accounting?
Under accrual accounting, you record income when it is earned and expenses when they are incurred, even if the actual payment takes place at a different time.If you finish the $2,000 project in December, you will usually recognise the revenue in that month even though the customer makes the payment in January.This method provides a more accurate view of how much your business has earned and how much it owes over a specific period, and the IRS defines the accrual method as consisting of recording income when it is earned and recording expenses when they are incurred.
The differences between cash and accrual accounting
The main difference between cash vs. accrual accounting is the timing of when transactions are recorded. In the case of cash accounting, the timing is determined by the date of payment. In the case of accrual accounting, the timing is determined by the date on which the income is earned or the expense is incurred.For example, let’s say that you draw up an invoice of $5,000 for a customer in March and get payment from them in April. In the case of cash accounting, the amount of $5,000 is shown as income in April.In accordance with accrual accounting, the amount of $5,000 is normally recognised as revenue in March, and the unpaid balance shows up as an accounts receivable until the customer makes payment.The same principle holds true in the case of expenses: under accrual accounting, the expense is generally recognised in March even if you pay the bill in April, whereas with cash accounting it is recorded when the payment is made.The SBA illustrates this difference with a simple example: in accrual accounting, the sale made in January, which is paid for in February, is treated as belonging to January, whereas in cash accounting, it is treated as belonging to February.
What about cash or accrual accounting for a small business?
There is no single solution that will work for all businesses. For a small service business with simple transactions, little accounts receivable, and a main emphasis on managing the cash at hand, the use of cash accounting may be appropriate.For instance, a freelancer, a consultant, or a small professional service business will find cash accounting easier to manage.Accrual accounting is more useful if your business has a regular stream of invoices, unpaid bills, inventory, employees, or more complex operations.It can also make financial reports more meaningful since revenue and the related expenses are recorded in the periods to which they belong.The SBA states that cash accounting is simpler to understand and clearly reflects cash flow, whereas accrual accounting gives a more up-to-date financial view but is more difficult to manage.
When to Use Cash Basis Accounting
Cash accounting should be considered if you want simplicity as a priority and your business does not have complicated receivables, payables, or inventory requirements.It can simplify everyday bookkeeping since the main thing you do is keep a record of the money you receive and the money you pay.The question of when cash-basis accounting can be used is also one that has tax implications. Although your business might be eligible to use the cash method, qualification depends on the relevant facts and the applicable tax rules.The Internal Revenue Service permits most small businesses in the United States to use the cash method, but there are some exceptions and special rules; businesses that are involved with inventory often have extra requirements.
When to Use Accrual Accounting
If your aim is for the financial statements to give a more accurate picture of business activity for each period, then accrual accounting is the good choice. It is particularly useful when customers plan to make their payments after they have received the invoices or when businesses have bills that are paid later.It is also important in the case where your business has to follow rules that require the use of accrual accounting for particular purposes. The IRS says that businesses, as a rule, should use an accounting method that clearly shows income, and a change of an already established accounting method may require the approval of the IRS.
The comparison of cash and accrual accounting with regard to taxes
The method you use for accounting can affect the timing of when income and expenses are recorded for tax purposes.With the cash method, income is usually recorded when it is received, and expenses are usually deducted when they are paid; with the accrual method, income is usually recognised when it is earned, and expenses are usually recognised when they are incurred, provided that the relevant tax rules apply.Remember, before you decide to change your method of accounting, you should consult a qualified tax professional; the IRS usually gives its approval for changes to certain accounting methods.
What accounting method should I use?
When you want to know which accounting method you should use, you should first consider the way your business actually operates. For a small and simple business, cash accounting might be easier to keep.Accrual accounting might be more useful if you have recurring invoices, unpaid bills, inventory, or if you want a better understanding of your monthly profitability.You should select a method that is suitable for your business and complies with the relevant accounting and tax requirements.
Conclusion
There is no complication in understanding the difference between cash and accrual accounting. Cash accounting is about the times when money is received or paid, while accrual accounting is concerned with the times when income is earned and expenses are incurred.Cash accounting is usually simpler and makes it easy to understand cash flow. Although accrual accounting involves more effort, it can provide a clearer view of your business’s financial performance.
Frequently Asked Questions
What is the fundamental difference between cash and accrual accounting?In cash accounting, transactions are recorded at the time that money is received or paid; in the case of accrual accounting, revenue is recorded when it is earned and expenses when they are incurred, even if payment has not yet taken place.Is cash accounting more suitable for a small business?It is a viable choice for a number of small businesses since it is fairly simple and makes it easier to keep track of cash flow. Nevertheless, one should take into account the eligibility criteria and tax rules before going for it.What is accrual accounting?Under accrual accounting, business activities are recorded as they take place rather than waiting until payment is received. For instance, revenue can be recorded when an invoice has been issued for work that has been completed, even if the customer has not yet paid.Is it possible to switch from cash to accrual accounting?Although you might be able to alter your accounting method, some changes need the approval of the IRS. Refer to the rules that apply to
The main difference between cash vs. accrual accounting is the timing of when transactions are recorded.
In the case of cash accounting, the timing is determined by the date of payment. In the case of accrual accounting, the timing is determined by the date on which the income is earned or the expense is incurred.
For example, let’s say that you draw up an invoice of $5,000 for a customer in March and get payment from them in April. In the case of cash accounting, the amount of $5,000 is shown as income in April.
In accordance with accrual accounting, the amount of $5,000 is normally recognised as revenue in March, and the unpaid balance shows up as an accounts receivable until the customer makes payment.
The same principle holds true in the case of expenses: under accrual accounting, the expense is generally recognised in March even if you pay the bill in April, whereas with cash accounting it is recorded when the payment is made.
The SBA illustrates this difference with a simple example: in accrual accounting, the sale made in January, which is paid for in February, is treated as belonging to January, whereas in cash accounting, it is treated as belonging to February.
