One important thing a business owner has to do when setting up their business is determine how they are going to handle their accounting. Many people operate their business accounting like a checkbook, but that’s not always the best option. A checkbook typically follows the cash accounting method, but for a business, using the accrual method may be a better option. Before you decide which method works best for you, let’s take a look at how cash accounting and accrual accounting work and in what ways they’re different.
What Is Cash Accounting?
While both methods of accounting are valid and can be used, cash accounting does seem to be the default for new business owners. This is because it is essentially how most people keep their checkbooks or online banking. It’s an easy method to use.
Cash accounting simply adds to the account when you receive a payment and deducts from the account when you pay something. It doesn’t take into account any invoices, bills you haven’t paid, or anything other than cash you have on hand or have actually spent. It doesn’t deal with account payable or accounts receivable at all.
When you look at your account, you will know exactly how much money you currently have on hand. You don’t need to do any math or take into account any outstanding invoices or bills—you know exactly what resources you have on hand. Cash accounting is easy for most people to understand and perform, especially for those who don’t have a degree in accounting and have a relatively small business.
However, cash accounting isn’t perfect. One of the biggest downsides is that it only looks at what you have currently spent. If you have bills for several thousand dollars that you haven’t paid yet, those expenses aren’t considered. This means if you spend too much, you may not have the funds on hand to pay those bills. You also aren’t taking into account outstanding invoices and other money that’s coming in. You could avoid making a necessary purchase because it looks like it would run your account low, when in actuality, you have a large amount of money coming in soon and could make the purchase.
What Is Accrual Accounting?
Accrual accounting, on the other hand, tracks expenses and income when they are billed or invoiced for. In other words, when you ship out a product with an invoice to a customer, you record that invoice as income right away. You don’t wait until the customer pays that invoice. Transactions are recorded when they occur, not when they are paid for. While the cash accounting method may seem more intuitive to new business owners, when all businesses are taken into account, most use the accrual method.
There are a few different reasons for this. First, it gives you a larger, more accurate idea of where you stand. You know what expenses you’ve committed your funds to, so you don’t have to worry about spending so much that you can’t cover your bills. You also know what you have coming in, so you can make purchases or payments as needed knowing that you have money coming in.
However, on the downside, you do have to keep an eye on your actual bank account. You may have thousands of dollars in outstanding invoices on your books, but if those clients haven’t paid you yet, your actual cash on hand may be much, much less. You could easily overdraw your account if you spend based on what you will have rather than what you currently have. You will need to carefully keep an eye on your accounts and on your actual cash flow to make certain this doesn’t happen.
How They Differ
Now that you have an idea of what cash accounting and accrual accounting are, let’s look at how they’re different. Cash accounting is focused on the money you actually have on hand and transactions that have occurred. Accrual accounting, on the other hand, looks at revenue you’ve earned or debt you have committed to, even if money hasn’t actually traded hands yet.
Example:
Let’s look at an example of how these two methods would treat a set of transactions. Assume that for one month, your business sent out an invoice for $2,000, received a bill for $500, was paid $1,000 from a previous month’s invoice, and paid $100 on a bill from the previous month.
If you were using the cash accounting method, you would only look at the cash that actually came in or went out from your accounts. This means your ledger would show a balance of $900. That considers the $1,000 payment you received from the previous month’s invoice and the $100 you paid out on the bill. The invoice sent for $2,000 and the bill you received for $500 aren’t recorded because you haven’t received that money or paid that bill yet. They will be recorded when that money actually comes in.
On the other hand, a business using the accrual method would show a profit of $1,500 for this month. That’s because it would look at the $2,000 invoice and the $500 bill you received. This method wouldn’t record the $1,000 payment for the previous month’s invoice or the $100 bill. Those two items would have been recorded in the previous month, so they would already be on your books.
Analysis of the Example:
In the accrual method, your overall account balance would show $2,400 to date because it would include the previous month’s invoice/bill, the recently sent invoice, and the recently received bill. However, the cash method would show $900 to date because the two unpaid items would not be included.
As you can see, this is a fairly large difference. However, both of these methods have their use. Let’s say you want to buy a new business laptop for $1,200. You would buy it right away, so there wouldn’t be a bill to pay. If you use the cash method, you wouldn’t make the purchase because you would see you only have $900 cash on hand. With the accrual method, though, you could make the purchase. It would instantly overdraw your account by $300, though, if you didn’t look at your cash on hand first.
On the other hand, if you need to buy something for $1,200 that will be billed, you may hesitate if you only have $900 on hand. If you know that you’ll have $2,400 once all outstanding invoices/bills are dealt with, though, you may feel more comfortable making the $1,200 purchase since you’ll know you will have the cash to pay that bill later.
How Each Method Impacts Taxes
The two methods impact your taxes differently. When you use the cash method, you report all income you actually received during the standard tax year. Likewise, you deduct any expenses that you actually paid. However, if you use the accrual method, you report income you’ve received plus any income you can “reasonably estimate.” This means if you invoice for a specific $1,257, you include that as income during the current tax year even if that money is not in hand. However, if you aren’t certain of the exact amount, you may need to make an adjustment. If you estimate $1,300 for income but actually invoice a client for $1,250, you will make the adjustment of $50 in the next tax year. The same is true of expenses. Include any expenses for debt that you have committed to, and make any adjustments during the tax year those adjustments occur.
Understanding how the two different methods affect your taxes can be confusing. The IRS has a number of regulations for each method. The best thing you can do is talk to a professional accountant or bookkeeper so you fully understand how to report your taxes every year. Better yet, retain the services of a professional so you know your tax reporting will be done accurately.
Which Option is Right for You?
Both methods are valid ways of accounting. However, typically, small businesses and other companies that do not actually sell products or have an inventory use the cash accounting method, while larger companies with inventory or that make a large amount of money per year should use the accrual method. Again, if you have any questions about which method would be the best for you, ask a professional.
Where can you find an experienced bookkeeper to ask? Here at Protea Financial, we have a staff of experts who are ready to assist you. Our virtual bookkeepers, payroll experts, compliant professionals, and others can help you with accounting and taxes. We will ensure that you are compliant with all IRS rules, report the correct income in the correct year, and take all deductions you are legally entitled to.
Our virtual bookkeeping services are perfect for small businesses that don’t need to hire someone full-time but still need an expert. If that’s what you need, give Protea Financial a call today to learn more about what we offer and how we can assist you with all of your financial needs.
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