As a small business owner, you've probably heard the terms 'cash- based' and 'accrual- based' accounting and are certainly using one or the other to run your business. However, have you ever asked yourself which is better for your business?
What are they?
Accrual and cash-based accounting are two ways in which a small business can keep track of the financial health of their business. Depending on the size and type of business, each has pros and cons, and it is up to the owner to determine which makes the most sense in their scenario.
Revenues and expenses are only recognized when payments are received, or bills are paid. For example, a sale made in 2022 may not be ‘realized’ until 2023 if no payment is received until then. This method relies of the adage, “Don’t count your eggs before they are hatched.”
Accrual based accounting employs the matching principle and the revenue recognition principle. These state that 1) expenses should be recognized in the same period as the revenue they help generate. 2) revenue should be recognized when the business performs the actions that entitles it to the revenue.
Simply put, payments are accrued or accumulated until the service is rendered or the product is delivered.
Which is better?
Each method has its place. Review the pros for each listed below to help decide which route your business should take.
Focuses on liquidity (cash on hand)
Provides an excellent view of cash flow and doesn’t require a separate cash flow statement
Simplifies tax filing process
Good for businesses that don’t maintain inventory
NOTE: Despite its name, cash basis accounting has nothing to do with the form of payments accepted. A business can be paid electronically and still do cash accounting.
Focuses on revenue/expense/profit/loss
Required if your business extend credit to customers or lets them pay on account.
It’s the default for most accounting software packages
More accurate annual taxes
More accurate view of a company’s financial status—it provides a holistic view of the company’s health by including all types of accounts payable and accounts receivable.
Required if you want to get a bank loan for your small business
Recognized by the Securities & Exchange Council (SEC) and required for large and/or publicly traded companies.
NOTE: If you plan to do any of the things listed under accrual-based accounting in the future, it is probably best to use it today. Changing methods can be time consuming, costly, and require notifying the IRS and filling out Form 3115, Application for Change of Accounting Method.
So now that the basics have been covered, what does a real-life example look like? Let’s say you have 10 students who have agreed to sign up for 10 classes from you over the next 3 months. Each are paying $100/class for one class per week. You decide to have them each pay for each class when they arrive.
In a cash-based accounting system you would recognize $100 as each student walks through the door and at the end of the week, you would have $1000 in your account. This continues each week, and you have a consistent flow of money coming into your account for the 3 months. Looks good right?
Yes, but…let’s change up the scenario slightly.
Instead of collecting $100 a week, you collect the full $1200 for the 3-months up front from each student. In a cash-based system, you would recognize all $12,000 in week 1 and for the next 11 weeks, it would look like your company wasn’t bringing in any money at all!
This is where an accrual-based system shows its value. In the second scenario, you notate that you collected all $12,000, but you accrue it—you set it aside in your records. You also note that you owe the value of 120 lessons to your students. As you deliver each lesson, you dip into bucket and apply it to an outstanding lesson. This is represented in a double-entry* accounting system.
This provides a perfect balance between what you’ve promised to deliver and the cash that you’ve received for services. Since you are tracking a lesson against a specific amount of cash paid, it makes projecting performance in the future much easier.
Now that you understand the pros and cons of each type of accounting, it is up to you to choose which works best for your business. If you are still unsure, please consult with your accountant before making any final decisions.
*Double-entry accounting is a method of bookkeeping. Information (transactions) must be entered into at least two accounts where one is a payable (liability) and one is receivable (asset.) For example, if a small business received a loan from their bank for $10,000 a credit in their ‘cash’ account for +10,000 would be created while in their ‘payables’ account a debit for -10,000 would be added. The benefit of double-entry accounting is it allows for easy detection of errors and helps prevent fraud.