Cash vs accrual accounting – Which one does your business need?
Cash basis accounting and accrual accounting are two sides of the same coin. There are some major differences, but they are similar in concept because the end goal is to do the back office accounting of a business. Suppose you handle your accounting work in-house or want to get outsourced accounting services. In that case, you must become more aware of accounting basics to communicate better with your accounting team.
Cash basis provides an immediate reflection of the revenue in hand and expenses, and the accrual method predicts revenue and expenses based on transaction history. They are both methods for financial reporting and but no matter which one you choose, you need to keep using the same process consistently. It is better to become aware of all there is to know about both processes to understand which will work best for your business.
Read this article to find out which one is best suited for your business and start your accounting journey with the right understanding.
What is the difference between cash and accrual accounting?
Accrual accounting paints a clearer picture and is the more popular choice for many companies, but a cash basis also has its own good sides. Cash basis accounting only records income and expenses as and when the bills are made and paid. But accrual accounting records income and expenses based on bills and earnings. And if you are a company whose annual revenue is somewhere below $25 million, then there are no set GAAP or rules of accounting for you that the FASB will hold you accountable to. You can use any method that suits you.
Which Businesses use cash basis accounting?
Cash basis accounting is mainly used by companies or organizations with a single-person owned business or small enterprise with revenue below $25 million. It is easier to learn cash basis accounting for non-accounting people, making it very popular with new and upcoming businesses.
What does cash basis accounting look like?
Cash basis accounting is very straightforward. How? It only records expenses and incomes when they reflect on your account. For example, suppose you buy a product in September on credit from your company account, but the product gets delivered in October, and the money is deducted in October. In that case, the record will note it as an October expense. But this shows that your company had no business in September whereas you did have a business; the payment just came later.
The same goes for incomes, if you provide a service to a customer but the payment comes in two months later, the system will record it on the month it is received.
Who uses accrual accounting?
While many small businesses do use accrual accounting, they don’t need to use it. But if you have a $25 million annual revenue for three consecutive years, then you are bound to use the accrual method as mentioned by the FASB. This is a more complicated process and needs expert help for the process to be seamless.
What does accrual accounting look like?
The accrual method functions differently; this system records every time a service/product is billed, and money is earned. If you do work and it is billed in September, accrual methods record it for September, no matter when the money comes into your account. Even if the payment is not received and your account is yet to reflect the amount, it can also keep track of that.
This gives a more holistic picture of the company’s finances because it looks at all kinds of payments, even the ones stuck in the pipeline or the outgoing payments that will leave your accounts very soon. Hence, this method can help better prepare the company’s budgeting and forecasting system.
Top Things to Like and Dislike about Accrual Accounting
Let us figure out the pros and cons of accrual accounting to help you choose which one is better for your business.
- Creates a more accurate financial report for the company – helps you understand the customer buying and spending patterns.
- All GAAP guidelines are followed when you do accrual accounting.
- If you start using accrual accounting from the start of your business, you will never have to change the process, even if you scale up your business process.
- Requires a lot of resources and in-depth accounting knowledge. You will also need expert accounting help to smoothen the process.
- The biggest fault of this system is that it can give you an unclear picture of your cash in hand, which can be a financial disruption for a small business.
What to Like (and not) cash basis accounting
What are the pros and cons of cash basis accounting? Check them out.
- The process is very simple, and small businesses can figure it out in a shorter period. Hence it also uses less number of resources to function and saves money.
- Helps in tax payments too. Say you pay your taxes in April, and a work that was done in April but the payment came in June does not have to be filed in the same financial year. You can easily file this income in the next tax bracket.
- Not a holistic financial picture because it does not record business transactions when it happens but only when payments come through. No payments in the pipeline can be figured out from this system.
- The cash basis system keeps no records of the Accounts Payable and Accounts Receivable systems. It can become a problem to retrieve and track payments if you do not have the actual dates of payments.
- If by any chance your business exceeds the $25 million mark, you will be again required to shift to the GAAP guideline-based system and revamp your whole business process overview.
How do you choose the right option for your business?
For small companies that do not have a significant cash flow and major inventory to work with, it is always better for them to use the cash basis accounting method to avoid any more complicated and detailed bookkeeping processes. But if you work with a bulk inventory and complex business process with multiple stakeholders, it is best to go with accrual accounting to keep the process more transparent.
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