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Major Differences Between Cash and Accrual Accounting

Major Differences Between Cash and Accrual Accounting

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.

Protea Financial Accrual Accounting

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.

Protea Financial Cash and Accrual Accounting Differences

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.

Learn the Differences

Learn the Differences Between Cash and Accrual Accounting Today!

Get a Full Picture of Your Business with Accrual Accounting

Get a Full Picture of Your Business with Accrual Accounting

The cash basis of accounting is the method of recording revenue when cash is received and recording expenses when cash has been paid out. This method is easy and enables the business to legally manipulate taxable income. Paying less in taxes is as easy as spending more money.

The cash basis is common for small businesses that are not yet established. However, the Internal Revenue Service requires businesses to use the accrual method for inventories. As a result, some businesses adopt a hybrid basis where they use both the cash basis and the accrual basis. This is referred to as the modified cash basis of accounting.

Because there are so many advantages to using the accrual method, it makes sense to just commit to using the accrual method of accounting. We will explore what the accrual method is and why it makes sense to use it.

What is accrual accounting?

Accrual accounting is a method of accounting that records revenues when they are earned and record expenses when they are incurred, regardless of whether money has changed hands. The goal is to recognize related revenues and expenses in the same period. Accountants refer to this as the matching principle.

A quick example will better illustrate what this means. Your top salesman had a stellar month in January and sold $750,000 worth of merchandise, earning himself a commission of $7,500. Everyone hustled and it shipped by the end of January. The salesman was paid February 1. Under the accrual method the commission expense should be recorded in January, since the commission was for the sale generated in January.

What are the benefits of accrual accounting?

There are four major benefits to accrual accounting. First, the ability to match revenue with the related costs enables you to track profitability and better understand cash flow. As you track profitability, patterns will arise that will enable you to make better decisions. 

Second, it provides a more accurate picture of the state of your business than cash-based methods. The accrual method makes it easier to anticipate your expenses and predict sales. Being able to predict and budget are essential skills to be able to anticipate the needs of your business.

Because the accrual method of accounting provides a clearer picture of your business, many banks require financial statements to be prepared accordingly. This makes it easier to obtain credit and expand your business to meet market demands.

Third, it is compliant with Generally Acceptable Accounting Principles (GAAP). GAAP is a collection of accounting standards and industry practice that have been developed over many years. This one is huge because it puts everyone on the same page. Accounting is commonly referred to as the language of business. GAAP ensures that everyone is speaking the same language.

Last, GAAP makes it easy to answer the question “How are we doing?” Because GAAP creates one standard for everyone it makes it easy to compare the current period to past periods.

Even more, you can compare how you are doing to how others in the industry are doing. For example, pretend you are a producer of red wines. You can look up publicly traded wineries like Vintage Wine Estates ($VWE) or Willamette Valley Vineyards ($WVVI), which are both listed on the NASDAQ. Look up their statistics on Yahoo! Finance to get an idea of what how they are performing. Knowing how others in the industry are performing gives you an idea of what your numbers should be. 

Creating metrics to gauge your financial performance is a whole other—but exciting—conversation. To show you what is possible, $WVVI, who started publicly trading in 1994 enjoys a 10.28% profit margin. Whereas $VWE, who recently started publicly trading only enjoys a 4.52% profit margin. What does $WVVI know about wine making that $VWE is missing, as illustrated in the stark differences in profit margins?

 

Accrual Accounting and Protea Financial

Although accrual accounting takes more time because it can be complicated, the advantages outweigh the disadvantages. It enables you to track profitability and better understand cash flow, which provides a more accurate picture of your financial position. In addition to being compliant with GAAP, it also provides useful information for making business decisions about inventory purchases, investment opportunities, and financing needs.

Accrual accounting is more than cash transactions; it provides information about assets, liabilities, and earnings. Accrual accounting provides a better view of your overall financial position. Because the accrual accounting method is consistent with GAAP, the rules to prepare financial reports of both public and private companies are oftentimes a more accurate method for most companies.

For more information about accrual accounting or other business accounting basics subscribe to our blog for updates. 

Tax Preparation Enablement

We provide your organization a true end to end solution to all of your tax needs. Tax season is year round to Protea – if you aren’t preparing daily, it’s too easy to get behind. We are always working with your organization to streamline your businesses tax management.

Accrual Accounting vs. Cash Accounting – What’s the Difference?

Accrual Accounting vs. Cash Accounting – What’s the Difference?

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. 

Cash basis

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.

 

 

Accrual basis

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.

 

Cash basis

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.

 

Accrual basis

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?

Cash Basis

Pros
Cons
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

 

Accrual Basis

Pros
Cons
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.