In today’s post, we’re going to explain a pretty confusing concept in accounting and business.
A concept that a lot of entrepreneurs and even accountants have trouble wrapping their heads around.
And that is the difference between cash vs accrual accounting.
We have a client that previously was doing their books with accrual accounting and when we reviewed their cash balances…
…the income in their books and cash in the bank was completely different.
Long story short, he thought he was making more than what was in the bank account and couldn’t understand why his 8-figure business, only had 6-figures in the bank.
The answer had everything to do with cash vs accrual accounting.
Or another example…
Maybe you enter an invoice in QuickBooks but it’s not showing up on your profit & loss statement… Well, why is that? Did you do something wrong?
The answer is related to cash vs accrual accounting.
Both are completely different methods and impact how you report sales and expenses in your business, and even impact your taxes and what you owe there.
Let us go ahead and show you the difference in a financial report between cash and accrual accounting.
Sometimes it’s just easier to see the difference so you can know exactly what we’re talking about.
As you can see, we’re in QuickBooks, and we’re in the reports section. Specifically for this illustration, we are going to look at the Profit and Loss Statement or P&L.
First and foremost, you want to make sure that you select the period you want to run your report for. For this example, we are going to look at July.
Now before we hit the run report, do you see these two options under the accounting method?
There’s a reason they are here and that’s because it can make a big difference in how you review your financial performance and the amount of income that you report to the IRS.
This is what we are about to show you right now.
When we select accrual and run the report, you can see that sales are shown at roughly $87,000.
Now let’s go back and select cash and run the report.
Total sales are now at around $16,500.
Did you see that?
Under the accrual basis, this company is showing sales at $87k and profit at $82K.
Under the cash basis, this same company, during the same period, is showing sales at $16k and profit at about $14k.
Now, depending on the accounting method chosen, this directly impacts your tax filings and taxes owed.
So you definitely need to know more about this and understand this concept.
So let’s talk about this a little bit more.
Today, we will breakdown the:
- difference between cash vs accrual accounting
- pros and cons of each
- and tax implications
Let’s get started!
Difference Between Cash and Accrual Accounting
The biggest difference between cash and accrual accounting is the timing of when revenue and purchases are recorded in your books.
For example, let’s say you own a company, and you performed services in September and your customer paid you in October.
Under cash accounting, you would record sales in October: when the cash was actually received.
Similarly, if you received an invoice from one of your suppliers in September but paid the voice in October.
Again, that expense would be recorded in October, under cash accounting.
As you can probably see, with the cash basis of accounting, recordkeeping is only impacted by the movement of cash.
That is regardless of when services were performed or invoiced.
Benefits of Cash Accounting
Cash accounting is definitely more intuitive.
Most business owners think in terms of cash.
After all, cash is king and your business can’t survive without cash in the bank.
So under this method, you would have better cash flow management since your income statement would only show cash you have and the expenses you’ve spent.
Another benefit of cash accounting is its simplicity. There’s far less accounting work involved and you might find it reasonable to do this yourself.
A pitfall to consider with cash accounting is that it doesn’t necessarily show the complete picture of what’s going on in your business.
Accrual Accounting Explanation
But what about accrual accounting?
Again, the difference has to do with the timing of transactions.
Thinking back at our earlier example.
When you performed your service for your customer in September but was paid in October.
Under accrual accounting, you would record sales in September: when services were performed or earned.
Same with expenses. Only when your expenses are incurred do they impact your financials.
If you paid a vendor in October for services that you received in September,
September is when you incurred the expense and therefore when the expense should show up in your financial under accrual accounting.
Accrual accounting records revenue when earned and expenses when incurred, regardless of when cash was received or paid.
Benefits of Accrual Accounting
Accrual accounting shows a more complete financial picture of your business.
It depicts your sales and purchases as they are earned and incurred.
And even though the cash may not reflect these transactions initially, with time, cash will eventually match your revenue earned and purchases made.
But what happens when you earn revenue but haven’t received payment yet?
Well, you now know that revenue is recorded but you would also have a ‘receivable’ on your accounts showing that you are owed cash for the work performed.
This is where accrual accounting can become more complex.
You now have to manage your receivables and payables and create adjusted entries to those accounts once cash is paid or received.
The same is true when you received an invoice from a vendor.
The expense is incurred and recorded in the books but a liability account or payable is also recorded.
This shows that you owe someone for services or products received. A bit of extra step.
But it’s these additional details that make accrual accounting more complete.
IRS and Tax Implications
Most businesses default to the cash accounting method because of its simplicity and emphasis on cash flow management.
Also because the IRS only requires companies that have inventory, C-Corporations, or has $5M or more in sales to file using accrual accounting.
But note, if you want to change the method of accounting that you file taxes in, you must file the appropriate form with the IRS first.
Pretty much, the IRS doesn’t want you switching back and forth between accounting methods.
After all, in some years, it might be more beneficial to recognize income later than sooner to avoid paying more and save more on taxes in the current year.
But no, the IRS has already thought of that, and generally, you have to stick to one method.
Now switching gears a bit, we’ll let you in on our personal preference as a CPA…
We personally like to look at our financial statements on both a cash and accrual basis.
We believe that the accrual method gives us the best perspective on our business and how it is performing.
It tells us how much work we are selling and delivering on. It also tells us the real expenses we have.
On the flip side, cash basis is quick and effective. There’s no guesswork with trying to figure out how much cash we have and how much cash we’ve spent.
And at the end of the day, cash is the fuel that will keep our business going and we like to know those numbers as well.
There you go! Hopefully, you learned the difference between cash vs accrual accounting.
The biggest takeaway from this post is that cash and accrual accounting differ with the timing of the recording of revenue and expenses.
Under cash accounting, revenue is recorded when cash is received and expenses are recorded when cash is paid out.
Alternatively, under accrual accounting, revenue is recorded when earned and expenses are recorded when earned.
Cash accounting is suitable for smaller businesses that need to stay on top of their cash balances.
It has a simpler accounting process and is generally an accepted way of filing your business taxes.
Accrual accounting is suitable for larger businesses that need to have a more complete picture of what’s going on in the business.
Considering its complexity, having an experienced accountant would be better for those companies operating on an accrual basis.
If you did change your mind later on regarding your accounting method, no problem.
Just make sure the method you change it to is the method you truthfully want since the IRS doesn’t approve of much back and forth.
And for everything else concerning your business financial management needs, know that LYFE Accounting is always here ready to help you. Simply contact us today!