Cash Versus Accrual Accounting
There are two main types of accounting methods that you should be familiar with. Cash accounting and accrual accounting are both accepted methods of accounting, but both can produce very different amounts of net income.
The Main Difference
Cash and accrual accounting record revenues and expenses at different times. Cash accounting records revenues and expenses as cash changes hands. In the accounting world cash, checks, debit card transactions, credit card transactions, money orders, etc are all considered "cash," although the use of a credit card does result in a liability the liability is not with the person you purchased the goods/services from but rather with the bank.
Lets look at an example, if you sell an order and your customer promises to pay later you may extend them credit for 30 days. Under the cash method when you ship out the items you are not recognizing that sale because you have not been paid for the sale. When the client pays you in 30 days you recognize the sale as revenue. The same goes for expenses, if you receive a bill from a vendor, but you are not planning on paying it for another 20 days you don't record an expense. When you write out the check in 20 days you record the expense.
On the other hand with the accrual basis the sale is recorded when it is made regardless of when you will be collecting the funds. If you don't immediately collect money from your customer you record an Accounts Receivable. This means someone owes you money. If you receive a bill, regardless of when you plan on paying it, you record the expense. You also record an Accounts Payable, this means you owe someone money. When you pay the bill you decrease the Accounts Payable balance and decrease your cash balance, this shows that you owe less money to outside parties.
The Pros and Cons of Each
The cash method is easier to use, you are making one entry when you receive funds or pay funds and do not have to worry about recording Accounts Receivables (A/R) and Accounts Payables (A/P). A/R and A/P balances also have to be periodically adjusted in cases such as a client failing to pay you or if you fail to pay a creditor. But without those numbers on the books it is hard to tell what you owe someone and who owes you. The accrual basis gives a much better picture of the financial health of your business. With the cash method your income statement is showing actual cash in and cash out, with the accrual basis the net income also takes into account funds you have not received or paid yet. This means that the net income on the accrual basis is very different from the actual cash flows into and out of the business. It is important when looking at accrual financials that you are also looking at cash flow. The failure of a customer to pay you could also mean that regardless of net income on your accrual income statement you don't have the funds to pay your bills and could go out of business.
From a Tax Perspective
The IRS only allows certain small businesses to use the cash method of accounting when filing their taxes. That is because the cash method is easier to legally manipulate in some ways. You could for instance pay a large amount of expenses prior to the end of the year to decrease your net income for the year. You could also extend longer credit terms to clients at the end of the year in an effort to delay them paying you and you having to recognize net income. The issue with these approaches is you are then risking inflating your net income the following year unless the same actions are taken the proceeding year. Essentially you are just pushing back when you will be paying the IRS not decreasing the overall amount you are paying the IRS. This could also present a problem if you are climbing the tax brackets and really is something that a tax professional should help you with. The cash method for tax purposes ensures that you have the wherewithal to pay, in other words if you are preparing your taxes with the accrual method you may not have collected the funds from your customers and therefore may not have the cash on hand to pay the taxes on your net income. With the cash method you have already collected the cash from the sales in your net income and from a tax planning standpoint should have set it aside so you have the ability to pay your taxes.
The IRS does not like it when you change the method you are using, you are required to keep the same method unless you receive approval from the IRS. Some companies are not permitted to use the cash method at all and some companies in certain industries have other methods that may be available to them (such as the crop method for an agriculture business). When selecting a method for a new business it's important to talk to a tax professional about what provides your company with the most benefits.
Which One Should You Use?
Many of our clients actually use a combination of methods. They may use the cash method for tax purposes, but use the accrual method for their bookkeeping and financial information. Many accounting programs can prepare both accrual and cash financial statements from the same set of books. This means that an accrual income statement can be prepared for the client and their financial analysis, but a cash income statement can be prepared for tax planning and preparation. If you do not frequently issue credit to clients and you pay your vendors immediately there will not be much difference in the cash versus accrual basis and using either as a financial analysis tool is sufficient. Regardless of which one you use it is important to also realize the amount of actual funds that are available to you to pay your bills with. Understanding your cash flow is imperative to having a profitable business. It is also important to think about the added expenses that the accrual method may add to your business. At Honey Hive we do not charge additional fees for preparing books with the accrual method because we feel that the benefits the client receives from keeping a close eye on their A/R and A/P balances is important. However, there are a lot of bookkeeping services that will charge more for accrual books and it is something to consider when determining what method you will use.