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There are many different accounting methods used today by small businesses. Some are accrual-based, like cash flow projections and journal entries; others use a balance sheet approach to tracking the business’s assets and liabilities with no regard for timing of transactions. The difference between these two types of accounts can be confusing when it comes to analyzing financial statements.
Accrual-basis accounting is the standard method of accounting used by most businesses. Cash basis accounting, on the other hand, is an alternative that some businesses may use. The two methods are often confused and it can be difficult to tell which one a particular business uses. This article discusses the differences between these two methods of accounting with examples. Read more in detail here: distinguish between cash basis and accrual basis of accounting with examples.
One of the most crucial choices you’ll have to make when it comes to maintaining your company’s books is which accounting technique to utilize. Fortunately, there are just two choices: cash-basis and accrual accounting.
When using cash-basis accounting, you must record a sale or a purchase as soon as you pay a bill or get a check from a client. It doesn’t matter when you are paid by your client or when you pay your vendor under accrual basis accounting; a sale counts as soon as you give the service or product, and an expenditure counts as soon as you get your products or services from your vendor.
If you’re thinking about utilizing accrual-based accounting, we suggest using accounting software such as QuickBooks. Readers of Fit Small Business may save up to 50% on QuickBooks.
Go to the QuickBooks website.
The accrual vs. cash techniques will be compared in this article as follows:
What Is Cash-Basis Accounting and How Does It Work?
If you choose the cash-basis accounting approach, which is used by the majority of small firms, you will record sales and purchases only when money changes hands. Let’s look at a few scenarios to see how you’d manage sales and purchases if you used the cash-basis method:
Example of a Salesperson (Cash-basis method)
Let’s imagine you offered 3 hours of consultation to a customer, and you want to charge the client for those hours. This sale should not be recorded on your books until you get payment from your client if you are using the cash-basis technique. (when money is exchanged)
Example of Purchases (Cash-basis method)
Assume you’ve just bought a printer and a few laptop PCs for your workplace. You ask the vendor to deliver them overnight, but the vendor bill does not appear for another two days. This purchase is not recorded on your books until you pay the seller using the cash-basis approach. (when money is exchanged)
What is Accrual Accounting and How Does It Work?
If you use the accrual accounting approach, you’ll record sales and purchases as soon as the services are completed or the items arrive. Let’s revisit our prior instances to see how the accrual accounting approach will affect them.
Example of a Salesperson (Accrual method)
Let’s imagine you offered 3 hours of consultation to a customer, and you want to charge the client for those hours. Because you delivered the services, this sale should be recorded on your books immediately under the accrual approach. It makes no difference when your consumer pays you; the accrual technique counts this as a sale.
Example of Purchases (Accrual method)
Assume you’ve just bought a printer and a few laptop PCs for your workplace. You ask the vendor to deliver them overnight, but the vendor bill does not appear for another two days. Because you have received your items, this transaction should be recorded on your books immediately using the accrual approach. It makes no difference when you pay for them.
Accrual-based accounting may be tough to monitor, so you might want to seek advice from Bench’s bookkeeping specialists. For as low as $299 a month, they can manage your books (billed annually). Your first consultation is complimentary.
Pay a visit to Bench.
Cash-Basis Accounting: Pros & Cons
As previously stated, the cash-basis accounting system is used by the majority of small enterprises. Let’s look at some of the benefits and drawbacks of employing cash-basis accounting in further depth:
Advantages of Cash-Basis Accounting
1. It’s simple to use
The cash basis makes perfect sense to most folks who don’t have an accounting education. A sale does not count until you have received money from your client, and a purchase does not count until you have paid for the items or services you have bought through this method. In a nutshell, transactions are only counted when money is exchanged, which makes this system extremely simple to comprehend.
2. Keeps track of financial flow
The cash-basis technique is all about cash flow in (sales to customers) and cash flow out (payments received from consumers) (purchases made from suppliers). Using this strategy, it’s simple to maintain track of your financial flow and avoid running out of cash.
3. In some scenarios, a lower tax bill is possible.
Because sales don’t count until you’ve received payment from your consumers, you may be able to save money on taxes. You will normally pay taxes on your business’s net profits (profit) for tax reasons. The fewer revenue (sales) you have to disclose, the smaller your net profit, and hence the lower your tax obligation.
As an example, suppose your total sales for the year were $50,000. You, on the other hand, only got a payout of $40,000. Because you only received $40,000 in “cash” as a cash-basis firm, you would only record sales of $40,000. You would owe taxes on Final Thoughts net profit, if any, after deducting your company expenditures. In this case, you will pay less taxes than you would if you had recorded $50,000 in sales.
While you have no control over when you get paid, you do have power over how much money you spend. If you decide to make a few large expenditures for your company before the end of the year, you may be able to deduct these costs from your tax return, resulting in a smaller tax burden.
The Drawbacks of Cash-Basis Accounting
1. There is no correlation between income and costs.
The cash basis technique does not effectively reconcile income produced with money spent on costs. If you buy things one month and sell them the next, this might be an issue.
For example, suppose you bought $5,000 worth of stuff in February with the intention of selling it to your clients. However, none of the things are sold until March.
As a consequence, when you close the books in February, you have a $5,000 spend with no income to balance it, causing you to declare a loss. You made a total of $6,000 in March by selling the merchandise.
As a consequence, you will have a profit of $6,000 when the books are closed in March. But you run your profit and loss reports, it will look that February was a terrible month (a $5,000 loss) and March was a good month (a $6,000 profit), when in reality you made a net profit of $1,000 over the two months.
2. Banks do not accept it.
If you want to receive a company line of credit or loan, you’ll need to present financial statements that are based on the accrual accounting system, which is what most banks prefer. The good news is that you can create financial statements using either the cash or accrual approach if you use QuickBooks.
3. In certain cases, the tax bill will be higher.
Because costs don’t count until they’re paid (under the cash basis approach), you won’t be able to deduct any expenses that haven’t been paid on your tax return, potentially resulting in a higher tax burden. As previously stated, you pay taxes on your business’s net profits (profit). The less costs you have to balance revenue, the greater your bottom line profit, and hence the larger your tax burden. In many circumstances, it may be beneficial to seek the advice of a professional. They know how to balance your income and spending to optimize your deductions.
Bench is a terrific place to start if you believe that’s the path for you. Their staff of bookkeepers has the knowledge and expertise to assist your company in managing its accounts and maximizing tax savings. Plans begin at $299 per month (paid yearly), with a free consultation included.
Pay a visit to Bench.
Pros and Cons of Accrual Accounting
Businesses that store inventory and have gross sales of more than $5 million dollars often employ the accrual accounting technique. Let’s take a closer look at some of the advantages and disadvantages of adopting accrual accounting.
Advantages of Accrual Accounting
1. All sales and purchases are visible.
Even though no money has changed hands, all sales and purchases are recorded using the accrual accounting approach. This allows you to keep track of money owing to you (often referred to as accounts receivable) and money owed to your vendors/suppliers (known as accounts payable).
2. Revenue and Expense Matching
The accrual system, as opposed to cash-basis accounting, performs a considerably better job of matching revenue collected to money paid out for costs. Let’s imagine you bought $3,000 worth of merchandise to sell to your clients in June. Assume you sold all of those things for $4500 to a number of different consumers. You’ve delivered the goods but have yet to collect payment from any of your clients.
Sales of $4,500 and costs of $3,000 would result in a net profit of $1500 ($4500 – $3000) for the month of June if you used the accrual method of accounting. Because sales and purchases are quick, you can instantly enter them in your records and display the real profit for June.
3. In certain cases, a lower tax bill is possible.
Expenses are recorded using the accrual approach as soon as you get things and/or services that you have bought, regardless of whether you have paid for them. This may be beneficial to you since you may be able to deduct costs from your taxes even if you have not paid for them.
Let’s imagine you decide to splurge and purchase everyone of your sales staff an iPad so they can travel without lugging along a large laptop computer. You place an order for iPads on your Apple account and get them on December 24, but you do not receive a charge until January 1. Because you got the iPads in December, they figure as a cost under the accrual approach. As a result, even if you haven’t paid for them yet, you may write them off as a tax deduction.
The Drawbacks of Accrual Accounting
1. More difficult to utilize
The accrual technique of accounting is more difficult to utilize than the cash method. As previously said, keeping track of your cash flow requires the usage of accounting software such as QuickBooks. You may run reports at any moment to check who owes you money and who you owe money to by generating customer invoices in QuickBooks and inputting your vendor bills.
2. To keep track of cash flow, you must utilize a cash flow statement.
The accrual approach of accounting fails miserably at keeping track of cash. Because revenue is recorded when a transaction is completed rather than when you receive cash from clients, your income statement may show a big amount of money even if you don’t have any cash on hand. This will need the usage of a cash flow statement to keep track of real cash in and out of your company. You can learn more about the cash flow statement and how to run one in QuickBooks by watching our video guide.
Let’s imagine you own a consulting firm and your days are packed with client meetings. Within 24 hours following their session, you send your customers an invoice that is due in 30 days. While your revenue may be large, your bank balance may be low if you have not received payment from your clients. Furthermore, if you are so busy that you do not have time to follow up with your clients concerning payment, you may be experiencing serious cash flow problems.
3. In certain cases, the tax bill will be higher.
If your sales are substantial, using the accrual method of accounting might result in a greater tax payment. All sales are counted under the accrual approach as soon as you perform the services or ship the items, regardless of whether your client has paid you. When adopting the accrual accounting system, you must include the sale on your tax return even if you have not received payment from your client.
4. Additional Accounts
You must utilize certain extra accounts that you would not typically require using the cash basis technique to keep track of outstanding invoices that have not received payment or bills that have not been paid.
Accounts payable, for example, is used to keep track of the money you owe to your vendors and suppliers. You’ll need accounts receivable to maintain track of your outstanding client amounts. On the chart of accounts, both of these accounts must be created. The chart of accounts is a system for categorizing company transactions such as invoices and bills from customers.
When Should Accrual Accounting Be Used?
As we’ve seen so far, most organizations will maintain their books using the cash-basis accounting system. However, there are several circumstances in which you may need to transition to accrual accounting. Let’s take a look at a couple of these scenarios:
1. Annual Revenue is more than $5 million.
As long as your total sales does not exceed $5 million, you may employ the cash method of accounting. Once you’ve reached this point, you’ll need to transition to accrual accounting. To notify the IRS of your change in accounting method, you must complete Form 3115.
2. You have a merchandise inventory.
If you have goods for sale and your gross revenues exceed $1 million, you must record all sales and purchases using the accrual accounting technique. This is basically to guarantee that your product sales income and inventory costs are more fairly matched (commonly known as cost of goods sold).
The accrual accounting technique must be used to appropriately compute the cost of goods sold. Rather of counting the cost of things at the time of purchase, as with the cash-basis technique, you should record the cost of products as they are sold. To put it another way, you’ll record an item’s income and expense at the same time. This provides a balanced revenue-to-expense ratio.
3. Lots of A/P and A/R.
If you send out a lot of invoices to clients or have a lot of suppliers that send you bills, you might think about adopting accrual accounting. It will assist you in keeping track of your accounts receivable and payable.
If you don’t have a system in place to handle customer invoices and vendor bills, you should look into adopting QuickBooks. You can set up all of your clients’ payment arrangements in QuickBooks. You’ll get a reminder when a client invoice is due so you can follow up and make sure it’s paid on time.
You may set up your suppliers using the payment conditions that they have provided to you in the same way that you can set up your consumers. QuickBooks will remind you to pay your bill when it becomes due. Maintaining a solid cash flow requires staying on top of A/P and A/R.
4. Obtaining a Business Loan
As previously stated, banks and financial organizations favor accrual accounting over cash accounting in their financial accounts. As a result, if you want to apply for a company loan or line of credit, you should think about altering accounting techniques so that you can present financial statements that fulfill the majority of bank standards.
You may, however, prepare financial statements using either technique (cash or accrual) at any moment if you utilize accounting software like QuickBooks. If you’re not quite ready to move away from cash-basis accounting, this may be a lot more convenient. Please have a look at our free QuickBooks course. It contains both video and textual tutorials so you can get started right away!
Final Thoughts
You should have a clear knowledge of the main distinctions between accrual and cash basis accounting at this point. Remember, unless you fit into one of the following categories, you’ll be using cash-basis accounting.
- Your gross revenues are in excess of $5 million.
- You have inventory and gross revenues of more than a million dollars.
- You send out a large number of client invoices.
- You get a lot of vendor invoices.
- You intend to apply for a business loan or credit line.
Remember to look into QuickBooks to spare yourself a lot of hassles in the accounting department. To get a 50% discount on your membership, click here.
Go to the QuickBooks website.
The “cash basis vs accrual basis accounting pdf” is a document that describes the difference between these two methods of accounting. The “cash basis vs accrual basis accounting pdf” is a document that describes the difference between these two methods of accounting.
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