What is the difference between Cash and Accrual basis accounting? Does one provide more benefits than the other? Is there any legal reason why I should choose one over the other? These are questions that many business owners ask. I hope this article will be able to provide you with some clarity on this topic.
What is Cash Basis Accounting? Cash basis accounting is a method of accounting in which money is accounted for upon changing of hands. For example, income is counted when you receive a payment from your customer. Expenses are counted upon paying the bill. Only those transactions where money changes hands are counted on the tax return.
What is Accrual Basis Accounting?
Accrual basis accounting is a method of accounting wherein the income and expenses are counted at the time they are incurred. For example, when you receive an order of supplies, that is when the expense is considered your expense, rather than when you pay the bill for that order (as in cash basis). This means that all outstanding bills and debts are considered expenses whether they are paid or not. Income is counted upon completion of a job for a customer, not when the customer actually pays you. Therefore, all accounts receivable (ARs) are considered income, whether or not they were collected.
Which Method is Easiest?
No question, cash basis accounting is the simpler of the two. For most small businesses cash basis is the preferred method. It doesn’t require entering bills into your accounting software or keeping records of your accounts receivable, though it is not advisable under any circumstances not to keep AR records.
At tax time, with cash basis, the money you collected and the money you spent is what your accountant will use to fill out your tax forms. With accrual it gets a bit more complex, as what you owed as of 12/31 and what was owed to you as of 12/31 will need to be reported.
Why Use Accrual Method at All?
Accrual based accounting is a more accurate method of accounting, as it keeps the expenses and income in the same period where they were expensed or earned. For example, take a construction company with a large project that starts in February 2022 and completes it in December 2022 and the income collected for that job comes in in January of 2023. If the expenses for this job came in at $225,000 and the income was $345,000, cash accounting would show all those expenses in 2022 and no income at all to balance them out, whereas accrual accounting would show both in 2022 and so would show a $120,000 profit, rather than a $225,000 loss. It gives a clearer picture of the financial scene.
Some businesses are required to use accrual basis accounting based on their annual revenue. The threshold for this, I believe is $25,000,000 but verify this with the IRS for yourself, as it may change.
There are also some industries that are required to use accrual-based accounting, such as product sellers who retain inventory, (as there is no accounting for inventory on a cash basis) and government contractors who are required to provide all of their accounting documentation periodically over the course of the contract. Click here to see a publication from the IRS to help you determine if your business meets the requirements for accrual-based accounting.
I hope this article has been helpful to you in making the right decisions for your business.
If you have any questions about bookkeeping or are considering hiring a bookkeeper for your business, please feel free to contact us at firstname.lastname@example.org.
About the Author I have been doing bookkeeping for about 20 years and concurrently held a position as the head of HR for a small management firm for 14 of those years.
Currently, I am an owner of Peggy’s Bookkeeping Service with my partner and mother, Peggy. Peggy’s Bookkeeping is a small, family-owned bookkeeping service based in Clearwater, FL. You can visit our website at www.peggysbookkeeping.com.
Disclaimer: The content on this page is for informational purposes only, and does not constitute legal, tax, or accounting advice. If you have specific questions about any of these topics, seek the counsel of a licensed professional.