The difference between accrual and cash accounting is the timing of when sales and purchases are recorded in your books. Accrual accounting recognizes revenue when it is earned and expenses when they are billed but not paid. Cash accounting acknowledges revenue and expenses only when money changes hands.
Here is a look at both methods in detail and how each one affects your business.
Cash Basis Accounting
The cash basis of accounting recognizes revenue as expenses are paid and cash is received. This method does not recognize accounts payable or receivable.
Many small businesses choose to use the cash basis of accounting because it is simple to maintain. It is easy to determine when a transaction has occurred as the money is in or out of the bank. You don’t have to track receivables or payables.
The cash method is also beneficial for tracking how much cash the business actually has at any given time. It allows you to look at your bank balance and understand the exact resources at your disposal.
Also, since transactions are not recorded until the cash is received or paid, the business’s income is not taxed until it is in the bank.
Accrual Basis Accounting
Through this method of accounting, revenue and expenses are noted when they are earned, regardless of when the money was really received or paid. For example, you would enter the revenue when a project is finished, instead of when you get paid. This method is used more than the cash accounting method.
The advantage is that the accrual basis gives a more realistic idea of expenses and income. It provides a long-term view of the business that cash accounting cannot.
The downside is that accrual accounting does not provide an awareness of cash flow. A business can appear to be making a profit when, in reality, it has empty accounts. Accrual accounting without careful monitoring of cash movement can have disastrous results.
The Effects of Accrual and Cash Accounting
Understanding the difference between accrual and cash accounting is crucial, but it is also necessary to put them in context by examining the direct effects of each method.
Choosing an Accounting Method for your Business
You will need to choose an accounting method when you file your first tax return for your business and then use it consistently on all subsequent returns. A trusted accountant can help you decide which accounting method works best for your business.
Be aware that some businesses must use the accrual method, so the specifics of your business may dictate which you choose. For help selecting the right method or with any other business financial questions, contact Padgett Business Services. We prepare thousands of income tax returns each year, quickly and efficiently. We get to know you and provide a level of service that you can’t get from walking into a seasonal office once a year. We are here all year round. Call us today to learn more.