Accounting: Cash vs. Accrual
Many struggle with these two accounting methods. Both are completely different in how you report your sales and expenses. But more importantly, it impacts how much you'll owe in taxes.
Key Takeaways
The biggest difference between cash and accrual accounting is the timing of when revenue and purchases are recorded in your books.
Accrual accounting reports are revenue and earned and expenses when incurred, regardless of when cash was received or paid.
Accrual Accounting vs Cash Accounting
An accounting method refers to the rules that a company follows when reporting income and expenses. The two primary methods are: Cash basis accounting and accrual basis accounting.
And the difference between the two has to do primarily with timing.
The timing in which you record the income and the timing in which you record the expenses. Like everything in life, timing is everything. Let's start with cash accounting.
Cash Accounting
Cash accounting is a relatively simple concept. Basically, a business records income and expenses as they actually incurred. So, whenever the income comes in, that's when it's recorded. Whenever the expenses go out, that's when it's recorded.
Because it's so easy, it's so widely used. In fact, most of us use the cash accounting method when managing our personal finances. It's an appropriate accounting method for most businesses of a certain size and a certain industry. But once a business starts to get more complex, where the revenues are much higher (maybe in the multi-million dollar mark) or maybe they have some inventory and some receivables, then it may be time to start using the accrual method of accounting.
Before we move on to the accrual accounting method, let's talk about the main drawbacks of the cash accounting method. While it is really simple to use, the main drawback is that it may not accurately present your financials.
For example, if you are accounting for bills that you'll have to pay in the future, you might appear to be more profitable than you actually are. If you aren't accounting for income that you're going to receive, then your revenue might be stated lower than it actually is.
Cash accounting can either overstate or understate a set of financials depending on whether the business had low or high accounts receivable or accounts payable in any given period.
Accrual Accounting
Accrual accounting has to do with the matching principle. Essentially, you're matching the expenses with the income. By matching your revenue with your expenses, you get a clearer picture of your financial condition.
Under the accrual method, transactions are recorded when they are incurred. What does that mean?:
It means that if you expect income to come in, an invoice is created, you have an accounts receivable on your balance sheet, and you have the revenue on your income statement.
This method of accounting can be perceived as tedious. So it is beneficial for a company that is more complex or larger.
Modified Cash Basis Accounting Method
The modified cash basis accounting method is a hybrid. It's not something you use on your tax return, but it is something that can be used in managerial financial statements. Basically, what it means is: you accrue some income and some expenses, but not all of them because it's not as strict as the full accrual accounting method. It can be a little bit easier to use than the full accrual accounting method, but still present a better financial picture than just the fully cash basis accounting method.
Determining what accounting method to use is an important conversation to have with your CPA.