Cash Basis Vs. Accrual Basis – Which One is Best for Your Business?

When first starting a new company, every business owner must decide how and when to recognize the income and expenses their business will generate and incur. It is important to note that this decision must be made before the initial business tax return is filed. There are two approaches - cash-basis and accrual-basis.

What is cash-basis accounting?

The short answer is that income and expenses are only recognized when money is exchanged, regardless of when goods or services are rendered or delivered.

Examples:

• If you are wrapping up a project for a customer in May, but you do not receive the final payment from the customer until June, June is when you will recognize the revenue on your financials.

• If you have a repair bill for a piece of equipment that is due on the last day of the month, you will not record the expense until the money leaves your bank account, which could happen the following month depending on the bank processing times.

It is important to note that this method does not introduce the additional complexities of accounts payables, receivables.

Advantages of the cash-basis method:

• Simpler, easier method with lower learning curve

• No need to evaluate receivables and payables for determining income

• Clear snapshot of immediate cash flow and cash position

• Generally, only will be taxed on income (cash) that you have actually received by year-end

Disadvantages of the cash-basis method:

• Misleading and inaccurate reporting: A business owner can show a profit by not paying bills during a period of time, even though they have incurred those expenses. This can skew the results of financial reports for the given period.

• Inventory management: In cash-based accounting, inventory is treated as an expense. It doesn’t become an asset until it is sold for cash. This can also misrepresent your financials, especially for businesses who have their capital tied up in inventory, or who hold inventory for long periods of time. The IRS restricts businesses that maintain inventories from using the cash method of accounting, with certain exceptions.

• Only recognizes income and expenses when money flows in and out of your accounts, instead of when transactions occur (i.e., when you may have a right to income, or you have accrued expenses).

What is accrual-basis accounting?

The accrual-basis essentially recognizes revenue when goods and services are rendered or delivered, and expenses are recorded when they are incurred regardless of when an actual payment is made or received. While this method provides a clearer picture and better insights into a business’ condition, it's also more complex than cash accounting.

Examples:

• If a business provides services to a customer in December, but does not receive the final payment until January of the following year, the revenue related to that service would be recorded and recognized as income in December, when it was earned.

• Let’s say that in September you prepay October, November, and December’s rent for the building your business operates out of. In September, the three months’ worth of prepaid rent is recognized as a current asset (prepaid rent). In October, you would then expense one month’s worth of rent and continue to do so through December. This matches the expense to the appropriate rental period, rather than one large expense recorded in September.

Advantages of the accrual-basis method:

• Accurate financial reporting: The accrual system accurately depicts a company’s profitability and financial performance during a period of time, perfectly correlating the sales and expenses arising from them during that same period.

• Improved planning and reporting: This system allows for analysis, planning, and strategic decision-making in organizations, with financial reports that match operating activities.

• GAAP compliance: Generally Accepted Accounting Principles (GAAP) mandate the accrual system of accounting. The accrual method’s compliance with these accounting standards is crucial if you’re looking to raise or borrow funds from investors and (some) banks.

Disadvantages of the accrual-basis method:

• Potentially pay income taxes on income where you did not receive the final payment from customer(s)

• It can also mask cash flow problems, making the business seem more profitable than it is, potentially leading to a cash crunch.

• Can also be time consuming and complex, with considerably more bookkeeping required to track not just cash, but also receivables, accounts payable and other matters to determine income.

The conclusion:

Ultimately, having a greater understanding of both cash-basis and accrual-basis accounting will help you select the best method for your company. This can provide you with the information you need to make well-informed financial decisions, the cornerstone of any business. If you are looking for more guidance in selecting the best accounting method for your business, contact us today!