Cash or Accrual? Why should you care?Sep 18, 2023
Cash Method and Accrual Method
These are the two different methods that can be used to record transactions in your accounting system.
Let’s dive into what they are, how they are different, and how the corresponding data can affect business decisions!
What is the cash method?
The cash method of accounting is the easiest of the two.
Your revenue is recorded when you are paid.
Your expenses are recorded when you pay them.
It’s like looking at your bank statement – your bank doesn’t care when your customer promised to pay you. It simply tracks when the funds were deposited. Similarly, your bank doesn’t care how long you’ve owed your vendor money, it simply tracks when the payment cleared the bank.
- When did the cash come in and what was it for?
- When did the cash come out and what was it for?
Pretty simple, right?
So, why the need for accrual?
Using the cash method leaves out quite a bit of information that can be useful when trying to figure out if your revenue is growing, how effectively you are using your cash, and what your actual monthly operating expenses are.
For example, if you buy 12 months’ worth of liability insurance at one time, the cash method records all of that in the month you paid for it – it was cash out, after all. Or if you pay your electricity bill late, you could see two payments in one month and none in the other.
On the revenue side, your P&L will show the increase or decrease in payments received, not whether you sold more or less.
Now, there are ways to adjust some of this data depending on your system and how you are entering the transactions. Many systems have the option to toggle back and forth between accrual and cash, but the accuracy of the data depends on how it was entered.
Before diving into that, let’s talk about the accrual method.
What is the accrual method?
The accrual method of accounting aims to record transactions in the period that they occurred, regardless of when cash was exchanged.
What does this look like in practice?
Sales are recorded on the day services were rendered – not when you were paid for them. When you look at your P&L, you can easily see if you sold more this month than last month.
The flip side of that is if your customer pays in advance of service, you don’t book it as revenue yet. Those funds are technically a liability because you would owe the money back if you can’t meet your obligations to the customer.
If you receive a bill from a vendor, the bill gets entered on the date of the bill, not when you pay for it. If you are purchasing a 12-month subscription, the total amount is split up over 12 months, not recorded all on the month it was purchased.
What this does – when properly maintained – is to easily let you see whether sales are up or down, if your expenses seem higher or lower than usual, how much money people owe you and vice versa.
Then you can dive into managing your collections and payables process to tweak cash flow.
Can you do both?
For consistency, you need to decide which method will be used in your accounting system. You can’t record using the cash method in January and change your mind in February. Most new businesses start out using the cash method and may choose to convert to accrual at the beginning of the new fiscal year if the needs of the business will be better met under accrual.
Sometimes, invoices and vendor bills are tracked in a completely different system so you can have visibility and manage collections and payments, but the accounting system is managed under the cash method. Or, accounts receivable may not be needed, but vendor bills are entered as Accounts Payable (A/P) for tracking purposes and paid on a schedule. A system like QuickBooks simply adjusts the financial reports to remove the A/P from the Balance Sheet if cash method is chosen for the report.
Sometimes, business owners choose to record their transactions on an accrual basis because they like the reporting but choose to file their tax return on a cash basis because they meet the requirements to do so and it’s more advantageous for them from a tax perspective. We’ll talk about that more in a bit.
Should you be on accrual?
The short answer is it depends on your business.
If your business mostly or always accepts payment at time of service and your expenses are pretty regular, then converting to accrual may not make much of a difference for you. If you have a lot of customers or vendors to manage on payment terms, then converting to accrual could provide better data to help you manage your cash flow better.
Something else to keep in mind is there could be outside forces that affect this decision. For example, the IRS has guidelines for how to determine if you can file your tax returns on a cash basis. If you don’t meet that requirement, then you’d have to use the accrual method. Another situation that could require you to change to accrual is financing. If you want to pursue a loan or line of credit for your business, one of the requirements may be to report on an accrual basis.
Start with these questions:
- Is there an external reason why using the accrual method is necessary?
- If not, what benefits could you gain from switching to accrual if you are currently on the cash method?
- Do you have systems in place that could provide what you need without changing your accounting method? If yes, are they working well enough that you want to move forward with them or is integrating them into your accounting system by converting to accrual something you want to pursue further?
Using your accounting method to your advantage
Since the cash and accrual methods record income and expenses at different times, your taxable income will not be the same under both methods.
What does this mean?
Let’s say you had $100,000 in revenue and a total of $80,000 in expenses for the year. Under the accrual method, your taxable income would be $20,000.
For the cash method, you have to ask a couple of questions.
How much revenue did you collect for the year?
How much did you pay in expenses for the year?
If you collected $80,000 in revenue and paid $75,000 in expenses, then your taxable income is only $5,000.
Your total revenue and expenses didn’t change, but the timing of the transactions can make a big difference between the two methods depending on your business model and accounting method.
Remember earlier when I mentioned that some businesses use the accrual method for their accounting but choose to report their taxes under the cash method?
This is why.
The difference in taxable income can be significant.
Not all businesses are allowed to do this.
The IRS has requirements for what kinds of businesses can file under the cash method, so if you are interested in learning more about this topic, consult with your CPA.
Something else to keep in mind regardless of which method you are using is that you can still use timing to your advantage at the end of your fiscal year.
Under the accrual method, you could choose to ship an order on January 1st instead of December 31st to change the tax year that the revenue would be counted in, assuming a December 31st fiscal year end.
Under the cash method, if you have the funds available, you could choose to pay bills that were due in January early in December to book the expenses in the current tax year, assuming a December 31st fiscal year end.
Strategies like these can be very effective in managing your cash flow and understanding at a deeper level how to maximize your potential.
It’s not just boring accounting stuff that us bean counters like to talk about!
Need help getting ready for next year?
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