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- How Does Cash Basis Accounting Work?
- How Does Accrual Accounting Work?
- Cash vs. Accrual Workflow Examples
- How Cash Accounting and Accrual Basis of Accounting Impact Taxes
- Who Uses Cash vs. Accrual Accounting?
- Cash vs. Accrual Accounting Takeaways
How Does Cash Basis Accounting Work?
You can think of cash basis accounting as how you might manage your own personal finances — cash in and cash out. As you purchase groceries from the store, money is (likely) withdrawn from your debit account immediately — and when payday rolls around, the funds from your paycheck are deposited into that same account. This deposit makes up for the money taken out when you bought groceries. The same idea applies when businesses operate on a cash basis of accounting. They recognize the revenue and expenses as they happen, which gives them a good idea of how much cash they currently have at their disposal. Because cash accounting recognizes revenue and expenses right as money is received and withdrawn, cash accounting gives you a good at-a-glance perspective of what’s actually in your bank account at any given moment. Some businesses choose to use cash accounting because it is easy to manage and convenient to make a decision on what you can and can’t afford. On the other hand, cash accounting can limit how businesses plan for the future, and might be unrealistic if your business is constantly sending and receiving invoices as part of business operations.Advantages of cash accounting
- Simple and quick accounting
- Accurate representation of cash flow
- Less staff and financial resources
- Can sometimes provide tax benefits
Disadvantages of cash accounting
- Not a great indicator of long term trends
- Does not account for payments that cannot be made immediately
How Does Accrual Accounting Work?
Accrual accounting is more commonly used for business accounting than the cash based accounting method. Rather than recording income and expenses as the funds are actually being processed, the accrual basis of accounting tracks transactions as they are billed and earned. This does not take into account whether the funds have been taken out of the account — or if they’ve been deposited, but rather counts on these transactions as events that will happen. Think about the days before venmo and other cash transfer apps when you wrote your friends “IOUs” as a promise to pay them back. Accrual accounting works on this same philosophy by recording transactions and assuming that the payment has already happened.Advantages of accrual accounting
- Presents a more accurate picture of how a business is performing in the long term
- Can be a more realistic model for businesses that invoice customers
Disadvantages of accrual accounting
- More complex than cash basis accounting
- Income taxes may be owed on revenue before payment has been received
- Less visibility into actual cash flow
Cash vs. Accrual Workflow Examples
Understanding how a cash vs. accrual accounting system might impact your bookkeeping can be tricky to visualize. Let’s go over some examples of what each might look like when accounting for your business.
Scenario A: Nonprofit
Let’s say your local radio station is running a fund drive to collect donations from the community. In a cash basis accounting model, the radio station would record your donation when you drop off the cash — or when your donation check is cashed. On an accrual accounting system, the nonprofit would count your pledge as revenue — whether or not the funds were actually transferred to the station.
Scenario B: Restaurant
Both cash and accrual accounting can work for a bar or restaurant business. Since these establishments expect customers to pay immediately, recording income is simple using the cash method. It works like this: when a customer signs their receipt or leaves cash on the table after a meal — the income is recorded. Easy, right? Where cash gets complicated is in the inventory process. In order to serve their customers, bars and restaurants rely on inventory being stocked by food and beverage vendors, which generally allow businesses a certain amount of time to make payment. On a cash method, the cost of inventory would only be recorded when the payment was made, rather than when it was ordered. This can complicate a few operational procedures. For one, this doesn’t give the chef and restaurant owner much information for when and how orders should be made. And second, the cash method doesn’t provide as much insight on how food costs stack up to their revenue. This can make it difficult to optimize their budget and plan for the future.
Scenario C: Rental Property
Imagine you own a rental property that you lease to tenants each month. You must report this income on your taxes to remain compliant with the IRS. If you opt for the cash basis of accounting, you will report this income in the year that you actually received rental payment from your tenants. And the same goes for your expenses — if you had to fix or buy a new appliance for your rental property, you would record this expense in the year that you paid the handyman or appliance store — not when you got the invoice or requested the work. On an accrual system you might not receive rental payment until the next tax year, but you would still record and claim the income when the payment was earned — whether or not the cash made it to your bank account. The IRS says most landlords use the cash method of accounting for rental properties, as it tends to be a simpler process for this business model.
How Cash Accounting and Accrual Basis of Accounting Impact Taxes
As explained in the rental property example, with cash accounting you report income in the year that you actually receive payment. This means you will be taxed on that income in the same year that the funds hit your account. To get a better understanding of how taxes are affected on accrual basis, let’s use a graphic design company for this example. Let’s say your company designed new menus for a restaurant and charged $1000 for the work upon completion of the project. You sent the invoice for $1000 in December 2018, so you went ahead and recorded this payment as income for 2018. But the work was not delivered until January 4th, 2019 — for which the client paid you $1000 on the same date. Since accrual accounting recognizes payment when it’s earned, not received, you can expect to pay taxes on the income from this project on your 2018 taxes. In contrast, had you used the cash accounting method, you’d be paying taxes on the $1000 payment in 2019 since you received payment that year.Payroll taxes
The accounting method you choose for your business doesn’t just impact your small business taxes, but it also can change how you pay your payroll taxes if you have employees. If you choose the cash basis of accounting, you will record the payroll tax each time payroll checks are written (when taxes are paid). Alternatively, with the accrual method, you would record payroll taxes as expenses you will pay monthly or quarterly. The accrual method can be a little bit easier to manage here, especially if you have a lot of employees. Plus, it can show you how much you owe so that you’re not tempted to make budgeting decisions you can’t actually afford.Who Uses Cash vs. Accrual Accounting?
As you know, there are different advantages and disadvantages for each method of accounting. So ultimately, which style of accounting you use depends on the structure of your company, applicable regulations, and your preferences.
Since cash accounting assumes that incoming and outgoing payments are made immediately, this accounting model is best suited for businesses without an inventory, sole proprietorships, and businesses who do not use invoicing to initiate payments.
Accrual accounting is the most common accounting method for businesses with an inventory. Since the cash basis method only records transactions when money exchanges hands, it typically doesn’t make much sense for businesses that buy and sell goods and services on credit. When a brick and mortar store stocks up on inventory for example, they might not actually sell their supply right away, or the payment could be processed at a later date. Accrual accounting works to solve this issue by noting when an inventory order was made (rather than paid), and when a sale was made (not received). This can help businesses plan for the future and get a better idea of how they’re performing.
Which accounting method should I use?
In order to keep your books straight — and remain in compliance with IRS regulations, you’ll need to determine which accounting method you’re going to use for your business when you file your first tax return. If you run a larger incorporated company, generally acceptable accounting practices (GAAP) may require you to use the accrual method for your business accounting. Keep in mind, GAAP is not law — and this requirement generally only affects publicly traded companies. Many publicly traded companies use cash accounting systems — unless they are listed with the Securities Exchange Commission (SEC). The reason for this distinction is that the SEC works to protect investors by providing insight about certain facts that relate to an investment, to help the consumer make a more informed decision upon investment. Not sure whether cash or accrual accounting is right for you? Check with a business accounting expert to see if there are any regulations on accounting in your industry, and see what method makes the most sense for you!