It is important for small business owners to understand the two main methods used in accounting: cash and accrual. Business owners, even if they don’t handle their own financial reporting, should know how each works, so that they can select the best bookkeeping practices for their businesses.
The main difference between cash-basis accounting and accrual accounting is the timing of when revenue and expenses are recognized. Using the cash-basis method, businesses would record revenue when the money is received and expenses would be recordedwhen they are actually paid out. This means there are no accounts receivable and accounts payable, as the record keeping only deals with actual money in and out. On the other hand, the accrual method recognizes revenue when it is earned and expenses when incurred, even when there has been no exchange of cash.
Let’s look at some examples:
Revenue Recognition: A business owner sells $10,000 worth of goods on April 1 and does not receive the payment until May 15. The business owner records the revenue for May, as that is when the cash actually comes in.
Expense Recognition: A business owner is billed in April and makes the payment in May. The expense is recorded for May, as that’s when the cash actually changes hands.
Revenue Recognition: Using the same scenarios as above: the business owner makes the $10,000 sale on April 1. This sale is recorded as revenue immediately, regardless of when the money comes in.
Expense Recognition: A business owner is billed in April but does not make the payment until May. The expense is recorded for April.
Clearly, the cash-basis method is simpler than the accrual method. As a consultant, with 16 years of experience in accounting, taxes and business consulting, I see many small businesses choose to use the cash-basis method given the ease of use. Businesses may often be understaffed and lacking the capacity to engage in the more complex method requiring more reporting and tracking. The cash method illustrates what a company’s bank account looks like, but the varying timing of cash receipts and expenses means the reporting does not necessarily provide “a true and accurate picture” of the company’s financials. The results also could vary between periods of high and low earnings.
The accrual method is more widely used by larger businesses. In fact, businesses with annual sales exceeding $5 million are required to use the accrual method for tax reporting. Companies that have inventories to account for their income also are generally required to use this method for purchases and sales, according to the IRS. The upside to using the accrual method is that it provides a more realistic picture of income and expenses during any given timeframe, and in turn, a more accurate idea of how the business is doing. The accrual method, however, does not account for cash flow and does not provide an immediate look into the business’ bank account.
Business owners are free to use either of the accounting methods, as long as their annual sales do not exceed $5 million. It is recommended, however, that businesses use the accrual method. Smaller, private businesses aren’t often being reviewed for accounting practices, but reporting using the accrual method is the only way of getting a true picture of the business.
Business owners with questions about these methods and the implications of using either could do well to speak with their CPAs or tax professionals to better understand what each method would mean for their own operations.