Accounting is a complex subject that some people tend to get, and others often struggle to comprehend. That’s where an accountant comes in to help companies with their bookkeeping and tax requirements.
We will be looking at both cash basis and accrual basis accounting to see the benefits and drawbacks of each. Both forms of accounting are recognized as GAAP (Generally accepted accounting principles)and present their advantages and disadvantages for businesses. Here’s everything that business owners need to know about cash basis and accrual basis accounting.
THE MAIN DIFFERENCE
The easiest way to understand the main difference between cash and accrual accounting is looking at the time when both revenues and expenses are recognized. In the case of cash basis accounting, revenues and expenses are immediately identified. When it comes to accrual basis accounting, the focus shifts to anticipated revenues and costs.
CASH BASIS ACCOUNTING METHOD
Cash Basis accounting is the standard form that most small business use and is what anyone studying accounting starts with learning. It’s incredibly basic, and everything is reported when money changes hands.
Revenue is only reported upon received cash, and expenses are only recorded when cash flows out of the organizations; this also means that there is no need for accounts receivable and accounts payable.
Cash basis accounting is mostly used for personal finances and by small organizations for bookkeeping.
ACCRUAL BASIS ACCOUNTING METHOD
One of the basic techniques that most accountants or CPA learn when starting with the subject is that revenue is accounted for the minute earned. In most cases, accrual accounting recognizes revenue before money ever changes hands or before a transaction occurs.
However, unlike the cash accounting method, revenues are recorded when the customer receives a product or service when it comes to accruals. There’s an expectation that the provider will receive money in the future. Similarly, expenses of the goods and services are recorded despite there being no cash allocated for those expenses.
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ADVANTAGES AND DISADVANTAGES
One of the main advantages of using the cash basis method is simplicity. It falls under the GAAP guidelines, and anyone can quickly get a grasp of bookkeeping using the cash basis method. Only accounting for revenues and expenses based on actual cash in-flows and out-flows makes tracking the cash flow of the company much more effortless.
However, a significant disadvantage of the cash method is that, on occasion, it can overstate the health of the company. Take a scenario where the company is rich in cash; however, they have massive sums of accounts payable (future expenses). If the accounts payable far exceeds the level of the company’s current cash in-flows and revenue stream, then the cash method will significantly overstate the health of the company.
That’s where the accrual method comes in and includes both accounts receivables and payables. Due to this, this method provides a more accurate representation of the profitability of an organization.
It’s particularly beneficial for assessing the long-term health of an organization. In the accrual method, all revenues are recorded when earned, instead of when they receive the cash. The same goes for expenses; the accountants include all costs the minute they are incurred.
Organizations might have certain sales in the current quarter that would not be recorded under the cash method because they would receive the revenue until the next quarter. As a result, investors looking at the books might conclude that the company is unprofitable when, on the contrary, the company is actually performing well.
The accrual method has its disadvantages as well. Its most prominent drawback is that it does not keep track of cash flow. As a result, it might not illustrate that company has significant shortages in the short-run and will continue to showcase profitability in the long term.
Additionally, accounting for expenses and revenues the minute they incur is not an easy task. It’s much more complicated than cash-basis accounting. Accountants will have to consider several additional items, such as unearned revenue and prepaid expenses.
WHICH METHOD SHOULD BUSINESSES IMPLEMENT?
While both methods have their advantages and disadvantages, a modern organization will employ both tandem methods to get the most accurate bookkeeping for their organization. By using both techniques, organizations can keep track of their short-term and long-term position at a high level. However, implementing both methods will not be possible without a CPA, and that’s an extra expense that small organizations must bear.
That’s not to say that there are not preferences; publicly traded companies generally tend to prefer the accrual method as it smooths out earnings over time. It allows these companies to effectively showcase their long-term profitability and attract investors.
In comparison, smaller organizations like retailers would definitely look incredibly profitable as consumers look to purchase during the holiday seasons. However, after the holiday rush, they would look unprofitable as consumer expenditure declines.
IMPACT ON TAXES
Both forms of accounting also have an impact on how an organization pays taxes. Under the cash basis method, the company would record their income upon receiving the cash. Therefore, they would pay tax on their income in the very same year.
However, under the accrual method, the company will record income the moment it is earned. That means that the income will fall under the taxable income for the current year, while the company won’t receive the payment until later on.
The IRS only requires businesses that are corporations averaging more than $25 million in gross receipts a year to use the accrual accounting method. Organizations that don’t meet the criteria have no obligation to use accrual accounting basis.
While both cash basis accounting and accrual basis accounting have their own advantages and disadvantages, many variables impact which method the organization should adopt. However, for a modern organization, there are advantages of using both methods in their bookkeeping. A combination of both can help organizations optimize their short-term and long-term health.
If you have any questions about your basis of accounting, let the team at Hall Accounting Company know and we will set up a time to discuss. Please reach out to Josh Hall at Josh.Hall@HallAcctCo.com or Jeremy Hall at Jeremy.Hall@HallAcctCo.Com for more information. From tax filing strategies to tips on bookkeeping and accounting, we’ve got you covered.