When reporting out of the general ledger, business owners need to choose between two different accounting methods: cash accounting or accrual accounting. The difference between these two accounting styles is cash ignores receivables and payables and accrual uses receivables and payables.
This article walks you through the advantages and disadvantages of each method, so you are better equipped to decide which is correct for your organization.
Cash Basis Accounting
Cash basis accounting represents the most commonly used method for small businesses because it is straightforward. In cash accounting, revenue and expenses are recorded during the period in which the money changed hands.
Therefore, income is recorded as soon as the business acquires the cash. In the same respect, expenses are paid as soon as the money goes out, not when the bill is received.
For example, a landscaping company bills one of their customers $4,000 for services on December 1st. But doesn’t receive the money until the following year, on January 15th. On a cash basis, this income would be recorded in January so no taxes on it would be owed for the year ending December 31st.
Let’s take a look at the differences in accrual accounting.
The accrual accounting method is when transactions are recorded as they occur, even if payment has yet to be exchanged. Typically, revenue and expenses are recorded before any money changes hands such as when an invoice or bill is received.
The use of accrual accounting is particularly helpful for businesses that offer credit on a majority of their sales, which means there’s a gap between invoice creation and receipt of payment.
When using either the cash or accrual method, you must employ double-entry accounting. Double-entry is a system of accounting that requires a two-sided book entry that “balances” for every transaction: the credit and debit sides must match in amount.
The double-entry system safeguards your organization as it protects your business against costly accounting errors. In addition, it provides a larger perspective of the money going in and out of the company.
Most modern accounting software uses double-entry accounting when entering an invoice or deposit into the system.
Despite being more challenging to implement, the main disadvantage of accrual accounting involves tax payments. It is possible to pay taxes on the income you haven’t received yet. If a customer’s payment is delinquent and you have already paid taxes on it, this creates more paperwork to implement a tax refund.
Per the IRS, cash accounting is only available if the business earns less than $5 million in average sales. Beyond $5 million in earnings, a company will need to implement the accrual method. Organizations that earn less than this can choose to do either cash or accrual accounting.
Additionally, if your company needs to perform an internal or external audit, the only method accepted is the accrual method.
Cash basis accounting has a few disadvantages. First, the cash method doesn’t factor in accounts receivable or accounts payable. Since these businesses are recording transactions when they receive them, it doesn’t forecast money coming in or future bills that are almost due.
Another setback with cash accounting is that it may not provide an accurate picture of the organization’s financial health. Let’s say a business just completed a large project for which they are still awaiting payment. Presently, this business would look less profitable in the period after which bills related to the project were paid but before the customer payment was received.
Therefore, cash accounting can both overstate or understate the condition of a business depending on collections or payments being high within a certain period.
Making a Choice
Accrual accounting better indicates business performance because it shows when revenue and expenses occurred. If you want to see if a particular month was profitable, this is easy to assess with the accrual method.
In real-time, accrual accounting provides a clear picture of your company’s profitability along with the ability to identify areas for improvement. To have a firm grasp of your business’s finances, you need to understand what your numbers mean and how to use them to answer specific financial questions.
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