If you’ve ever accessed your financial statements from your bookkeeping software, you might have seen options for “cash basis” or “accrual basis” statements. Even if you don’t produce your own financial statements, chances are, you’ve heard the terms “cash basis accounting” and “accrual basis accounting.” You might have even noticed these terms on your business’s tax return.
Your business accounting software, financial statements and tax returns don’t typically explain what these terms actually mean.
Accrual vs. cash basis accounting
It’s likely you want to know if it really matters whether you use cash basis accounting or accrual basis accounting for your business. After all, aren’t the numbers the numbers, regardless of what accounting method you use?
Cash basis accounting is sometimes referred to as “bank balance” accounting. With a few exceptions for non-cash expenses (things like depreciation, which doesn’t impact your business’s cash flow) only transactions that have cleared your checking or credit card accounts appear on your cash basis financial statements.
With accrual basis accounting, on the other hand, you recognize income and expenses when they are incurred. This is in accordance with both the matching and the revenue recognition principles of accounting — the two principles cash basis accounting disregards.
In other words, in accrual basis accounting, you record income when you earn it and expenses when they are used to produce that income.
First, let’s say your business is using the cash basis method of accounting.
Your business completed a sizable job in mid-June. Your customer paid you at the end of the month, but — because of the Independence Day holiday — the check wasn’t deposited until July 5.
When you look at your income statement for June, you become concerned. You thought June was a great month for your business, but you’re actually showing a loss because of all the expenses you incurred to complete the customer’s job.
You decide not to pursue similar jobs with other clients because you perceive this type of work to be unprofitable. Instead, you focus on smaller jobs with a different client base.
In early August, it appears your change of direction has paid off because July’s income statement shows a sizable profit. What isn’t obvious, however, is that July’s profit is actually from June’s activity and the type of work you’ve decided to no longer do.
It’s entirely possible that you lost money by focusing on smaller jobs in July, but the timing of the customer’s payment obscures this. You could continue running your business in an unprofitable manner for at least another month — and possibly longer — on inaccurate assumptions made from your cash basis income statement.
So, with this same example, let’s say you had instead used the accrual basis accounting method. In this case, you would have been able to see that the large customer job you completed in June was actually quite profitable. That’s because the income would have been recorded in June, when it was earned, instead of in July when the payment was deposited.
This is the revenue recognition accounting principle in action.
Accrual accounting goes a little further, though. Let’s say you’re using cash basis accounting and you pay your employees on the 1st and 15th of the month. This means that any labor costs your business incurs after the 10th of the month probably won’t flow through to payroll until the 1st of the following month.
In order to wrap up June’s large customer job, your team worked overtime in the days leading up to the project deadline. Because of payroll timing and deadlines, those labor costs weren’t paid until July 1, though.
This has the potential to skew your expenses, leading you to believe you were more profitable in June and less profitable in July than you actually were — unless you use accrual basis accounting. Under the matching principle, those additional payroll costs would have appeared on June’s income statement, giving you a true picture of June’s profitability.
Advantages of cash basis accounting
Cash basis accounting is the accounting method of choice for many business owners and their accountants. Accounting on a cash basis is easy to implement, maintain and understand.
Most individuals and businesses in the U.S. are cash basis taxpayers. If you maintain your books on a cash basis, there will be little difference between your financial statements and your tax returns.
This means your cash basis income statement can come pretty close to accurately mirroring your business’s cash flow statement — which is good news for business owners who want to get a snapshot of their business’s cash flow from just one financial statement.
Disadvantages of cash basis accounting
Based on this, cash basis accounting might sound like the superior accounting method. But there are some downfalls:
Cash basis accounting is not GAAP-compliant: If your business isn’t a publicly-traded company, you might not be overly concerned with this one. It’s important to keep in mind, though, that cash basis accounting disregards the matching principle and the revenue recognition principle of accounting. These principles are two of the 10 generally accepted accounting principles, or GAAP, that are recognized as the foundation of good accounting practices.
Cash basis accounting can give you a skewed perception of your business’s performance: Cash basis accounting recognizes your revenue as income when you receive payment. Similarly, it recognizes expenses when the money is spent. Often, income and expenses are recorded when the transactions are posted to your checking or credit card account. Therefore, using the cash basis method poses the risk that you’ll make inaccurate assumptions based on your cash basis income statement.
Cash basis accounting doesn’t take into account outstanding bills: When you use the cash basis method of accounting, your outstanding bills owed to vendors don’t appear on your financial statements — neither, for that matter, do outstanding invoice balances customers owe you. Similar to the example above, your cash basis financial statements might lead you to believe your business is highly profitable, when in fact you’re not even breaking even once you take your vendor’s bills into account. If your business relies heavily on accounts receivable or accounts payable, cash basis accounting will not give you an accurate view of your business’s financial position.
Advantages of accrual basis accounting
From our extended example above, you can already see the biggest advantage of accrual basis accounting — it can give you a more accurate picture of your business’s financial health. Additionally, whereas cash basis accounting does not conform to the GAAP, accrual basis accounting does.
Disadvantages of accrual basis accounting
There are several drawbacks of accrual basis accounting as well:
Accrual basis accounting can be time-consuming and difficult: It can take considerable effort to accurately keep accrual basis books, especially when it comes to expense matching. Additionally, accrual basis accounting can exceed the skill level of many small-business bookkeepers.
If you’re a cash basis taxpayer, accrual accounting can obscure potential tax liabilities: Although your tax preparer can easily convert your accrual basis statements to cash basis for tax purposes, if you only look at your accrual basis accounting statements throughout the year, you could be in for a shock at tax time. Your accrual basis statements might show you haven’t earned much of a profit for the year, but your cash basis financial statements — which are used to file your tax return — could show a large profit, meaning you could have a large tax bill.
Accrual basis financial statements can be a little more difficult to understand: In cash basis accounting, you can usually get a pretty good idea of your cash flow from your income statement. This is not the case, however, if you take sizable draws or distributions from the business, if you purchase a lot of assets or if you make large debt payments. With accrual basis accounting, on the other hand, you will have to rely on your cash flow statement in order to actually understand your business’s cash flow. Many business owners find the cash flow statement to be the most difficult financial statement to understand, but don’t let this deter you from using accrual accounting if it’s the best fit for your business. Your accountant or bookkeeper can help you understand your cash flow statement.
Which is better for your business?
When it comes down to it, we prefer accrual accounting vs. cash basis accounting. The insight you can get about your business from properly recognizing revenue and matching expenses can help you prevent costly mistakes in your business. But our preference doesn’t mean cash basis accounting won’t work for your business.
Although accrual basis accounting will give you the most accurate information about your business’s performance, the sheer complexity of it could outweigh the benefits. Plus, if your business doesn’t extend credit to customers or maintain open accounts with your vendors and suppliers, you’ll very likely be fine using cash basis accounting.
On the other hand, even if you do have accounts receivable and accounts payable in your business, you can run a simplified version of accrual basis accounting without going all-in on matching expenses to revenue.
Ultimately, you should talk with your accountant or bookkeeper about your business’s unique needs — making sure they understand what you want to gain from your financial statements and that they aren’t basing their advice solely on your business’s tax basis.
Once they understand how you plan to use your financial statements, your business accountant or bookkeeper will be able to help you choose the best accounting method for your business.
A version of this article was first published on Fundera, a subsidiary of webtradetalk.com.