Credit: Towfiqu Barbhuiya
When it comes to cash vs. accrual accounting, any financial advisor will tell you that accrual is the way to go. While cash accounting may be easier, accrual accounting gives you a better picture of your business’s operations and financial position.
Your accounting method will affect several things. First, it will demonstrate different things to investors. Second, it will change when you owe taxes on income or when you can declare expenses. Third, it will affect your ability to accurately budget and forecast.
The IRS has a much longer introduction to accounting methods. In this blog post, we hack through the weeds to give you the information you need to know as a business owner.
What is Cash Basis Accounting?
Cash accounting is definitely the easier of the two accounting methods. With cash accounting, your business records revenue and expenses when cash is received or paid.
If you’re unfamiliar with accounting, cash accounting might seem to be an obvious thing to do. In fact, many business owners don’t even know there’s any other way to do it.
With cash accounting, your accounting balance will always be identical to your cash base–the balance in your bank accounts. This method is simpler because it eliminates having to calculate accounts payable and receivable for accounting purposes. (Financers might want to know that information, however.)
The drawback to cash accounting is that your balance sheet position doesn’t necessarily indicate your true financial position. Accruals and deferrals are not recorded and therefore working capital is hard to measure. Just because you have a certain amount of money now doesn’t mean you haven’t already promised a portion of it to your vendors and lenders.
What is Accrual Basis Accounting?
Because cash accounting doesn’t account for upcoming expenses and revenues, businesses often opt for accrual accounting. With accrual accounting, revenues and expenses are recorded as they are earned or incurred, respectively rather than when received or paid.
Accrual accounting records accounts payable and accounts receivable. This often gives a better picture of your business. Because you are already subtracting accrued revenue and expenses, you and your investors can see how profitable your business is in the long run, after all expenses are paid and accrued income becomes liquid.
Investors prefer businesses that perform accounting on an accrual basis. Not only does it communicate a level of professionalism, but also helps them better judge your business. Because income and expenses are recorded as they’re earned and incurred, investors are able to get a better picture of your business’s historical performance and future profitability.
With accrual accounting, you get a more realistic picture of your profitability. Revenues and expenses are matched to one another.. This not only helps to attract investors but also to in budgeting, forecasting and overall financial planning.
Examples of Accrued Revenue and Expenses
It might be hard to conceptualize when the difference between cash and accrual accounting would matter. There are a number of common examples a business owner might come across.
- Transactions on Credit:This doesn’t mean payments with a credit card. Rather if you buy or sell goods and services with a payment date after receipt, you have made a credit transaction.
- Advance/Late Rent Payment: In the case of rental payments, you would always record the expense when rent is due, not when you pay it.
- Interest on Time Deposits: Even though you can’t access the interest earned on time deposits in the year it is earned, it is still recorded as income then.
- Insurance Premiums: If you have an insurance policy that does not begin at the beginning of the year, you will record prorated amounts across the two tax years, even if you pay the full year in advance.
As you can probably tell, accrual with these methods accomplishes two things. First, it lets you stay on top of your upcoming transactions so you aren’t beguiled by cash that’s already due to a vendor. Second, in some instances, it allows you to smooth transactions over a longer period of time.
Credit: Kelly Sikkema
Cash vs. Accrual Accounting: Pros and Cons
As with any choice you have in business, there are pros and cons to each option. Some pros of cash accounting include:
- Know easily when to record transactions
- Easy to check for accounting errors
At the same time, there are several disadvantages to cash accounting. They include:
- Large payments appear in lump sums, making budgeting across time periods difficult
- Less likely to find investors
- Difficult to plan your budget
By the same token, there are many advantages to accrual accounting. They include:
- Smoother balances from time period to time period
- Attractive to investors
- Budget forecasting easier
Despite the advantages, there are also cons of accrual accounting. These include:
- Transaction recording somewhat more difficult as needs to coded correctly
- Just because you have cash in the bank does not mean it is free to spend – so look deeper
At inDinero, we strongly encourage our clients to use accrual accounting. We believe it gives the fullest financial picture, allowing you to make responsible business decisions with your money. With your growing business, it’s the right move to make. Now the next question is who is the right partner to help as you grow up along this journey?
inDinero offers a full suite of financial services for businesses including accounting services, tax preparation, and budget planning. Contact inDinero today to get started with our financial services.