There are two methods for recording financial transactions in your books—the cash basis and the accrual basis. The primary difference between these two is the timing of when transactions get recorded.
Choosing a method depends on your business’s needs, and most wineries should use the accrual basis to value inventory properly. However, we’ll discuss both ways so you can see how each impacts a business.
Cash Basis Accounting
The cash basis of accounting records financial transactions when cash changes hands. When you receive money from customers, you record revenue. And conversely, when you pay your bills, you’ll record the expense. It’s that simple.
Although the cash basis of accounting generally doesn’t comply with Generally Accepted Accounting Principles (GAAP), it’s widely used by small businesses and new companies due to its simplicity.
And using the cash basis doesn’t necessarily require hiring an accountant with years of experience. A competent bookkeeper will easily be able to keep your cash-basis books.
Accrual Basis Accounting
Recording revenue when it’s earned and expenses when they are incurred is the basis of accrual accounting. When cash is received or used is irrelevant to the recording of the income and expenses
The foundation behind accrual accounting is the matching principle. This means that companies match expenses with related revenues to calculate profitability for a specific period.
For example, when you sell a case of wine, at the same time, you need to record the cost of the wine and any related selling expenses so, at the end of the day, you know your profit on the sale of that case of wine.
Accrual accounting will make use of accounts receivable and accounts payable to keep track of money owed to you and money you owe to others. These accruals allow you to match your expenses with the corresponding revenue.
For example, when you ship 20 cases of wine to your distributor with an invoice, those 20 cases’ sales price becomes a receivable to you. You earned the revenue by completing the sale but haven’t yet received payment.
The converse works for the money you owe to others. When you receive a shipment of glass bottles from your supplier, you incur the expense when you receive them. But you may not pay that invoice for 30 days, so you’ll have a payable on your books for the value of the bottles. Accrual accounting is more complex than cash accounting but does provide a truer picture of the profitability of your business.
Most larger companies and companies with numerous owners are required to use accrual accounting to adhere to GAAP principles. In fact, the IRS also has requirement on when accrual accounting must be used, namely for.
- most businesses with inventory,
- C-corporations, and
- companies with more than $25 million in annual sales.
Examples of Effects of Cash and Accrual Accounting
Effects on Income
Assume you sell 100 cases of wine for $1,000 to your top distributor and the total cost of making, bottling, and packaging that wine was $500.
You record the $1,000 in revenue when your distributor pays you.
You record the costs for the grapes, labor costs, bottles, etc. when you pay for those items, which was likely long before you sold the wine.
Gross profit reported at the time of receiving the cash from the distributor is likely to equal to the revenue.
You record the $1,000 in revenue when you deliver the wine to the distributor.
You record the costs of the materials and labor at the same time that you record the sales revenue.
Gross profit reported at the date the wine shipped (or a different date depending on the shipping terms) and will be equal to sales revenue less the cost of the wine.
You can see how the cash basis doesn’t provide a good representation of profit when your revenue gets recorded long after the expense shows up on the income statement.
Effects on Taxes
Using the same example of 100 cases sold for $1,000 at a cost of $500, the tax effect creates a similar mismatch.
You probably (due to the length of the inventory cycle in wine) recorded most of your costs in previous years, making your taxable income lower in those years.
But this year, when you record the $1,000 in revenue, your taxable income will be higher because you don’t have the offsetting expenses.
This year, you’ll be taxed on your $500 profit on this sale since you’ll record revenue and expenses in the same year.
You’re starting to see that the accrual basis creates more of a steady financial environment than the cash method’s peaks and valleys. Accrual accounting provides a clear picture of the profitability of a business as the income and expenses are matched.
Which is Better? Cash Basis or Accrual Basis
Choosing the correct accounting method will depend on your business’s specifics. Things to consider when deciding on a method include:
- Do you think you’ll need bank financing in the future?
- Is expanding the business to include more owners a possibility?
- Will your books ever need to be audited?
|Simple and easy
|Inaccurate financial picture
|Easy cash flow management
|No records of what you’re owed or what you owe
|Good short-term view
|Doesn’t comply with GAAP
|The better overall financial picture
|Requires more resources
|Commonly expected in business
|The short-term picture can be skewed
|Conforms with GAAP
Once you pick a method, you’ll want to stick with it for two reasons. Firstly, for consistency in your financial information. This way you’ll always be comparing apples to apples. Secondly, the IRS requires you to maintain the same method. If you ever want to change, you’ll need to ask for the IRS’s permission.
It’s best to consult with your accountant when selecting the accounting method that’s best for your winery and could be different for operational needs and tax needs. They can help you set up your accounting system and processes to ensure you’re recording your transactions correctly. You can also lean on them when you need expert help or additional hands to get the work done. Protea has decades of experience helping winery owners navigate the bookkeeping, accounting, and tax waters. Contact us today to see what we can do for you.