During business operations, several events occur which affect the financial statements and status of the business. These events are called accounting transactions. They include sales to customers, either cash or credit, paying the supplier for service rendered, investments, sales of assets, payment of employee’s salaries, etc. An important decision you will have to consider when setting up a business is the type of accounting method you’d like to employ in reporting revenues and expenses on your tax returns. There are three primary methods for recording accounting transactions: Cash basis, Accrual, and mixed cash accounting. You will do yourself a lot of good by weighing the pros and cons of these accounting methods and settling for the one that best suits your business. This is because once you agree to one, it won’t be a piece of cake to change it to another. The IRS only permits this on rare occasions.
- Cash basis accounting: This involves using cash inflow and outflow to report revenue and expenses as they are received or paid. In other words, the cash method shows how cash comes in and goes out of a business. Cash basis accounting uses single-entry bookkeeping. It covers only short-term transactions. Thus, accounts like accounts receivable, account payable, or long-term transactions do not apply here. This method is mostly used by individuals and small businesses. This method comes with some upsides, including:
- Its ease of usage: This method of accounting is relatively simpler, straightforward, and easy to maintain. A person without a sound knowledge of accounting can use this method easily.
- It gives you an insight on the cash at hand: Cash accounting is only concerned with the physical funds that come in and out of business. Hence you can easily see how much funds you have at hand.
- Tax advantage: This method offers a potential tax advantage for businesses. Since you can only record transactions when physical cash comes in or out, you can control the timing of transactions. Therefore, you can accelerate some expenses and slow down revenue, thus lowering your tax liability.
Despite the advantages that cash accounting gives, there is also a downside to it. The downside of this method is that it may fail to show the actual state of your company. For example, you might assume that your company is doing well because there is a lot of cash at hand, while in reality, there are some unsettled debts. Likewise, it could appear that the business is not doing great due to a lack of cash when many people owe you.
Accrual accounting: The accrual accounting method reports income (revenue) and expenses based on credit, accounts receivables, and accounts payable. This method doesn’t report revenue or expenses in relation to cash. Instead, revenue is reported when earned and expenses; when incurred. Accrual accounting is mainly required for businesses with more than $25 million in gross receipts over the last three years.
A major advantage of this method of accounting is that you know the actual state of your business, even on a long-term basis. In addition, with it, you can accurately tell if your business is profitable or not, and this is a good indicator for potential investors. The disadvantage of accrual accounting is that it is complex and can be catastrophic if cash flow is not properly monitored.
Modified Cash Basis Accounting/ Cash Accrual Accounting:
This combines both cash basis accounting and accrual accounting. Short-term assets such as rent, facilities, and internet are registered using the cash accounting method. On the other hand, long-term assets such as fixed assets and properties are recorded on an accrual basis. Cash accrual provides a deeper insight into your business financials compared to cash basis accounting.
What Are The Differences Between Cash And Accrual Accounting?
So many differences exist between cash and accrual accounting. They are as follows:
- What is recorded: The cash method records how cash comes in and goes out of a business. On the other hand, in the accrual method, revenue is recorded when earned and expenses; when incurred.
- Type of business: The cash basis accounting is used majorly by small businesses, While the accrual method is mostly required for businesses with revenue of over $25 million in gross receipts over the last three years.
- User friendly: Cash basis accounting is easier to use while Accrual basis accounting is more complex. However, the accrual method gives a better insight into your business performance.
- Kind of entry: Cash accounting uses single-entry accounting while Accrual uses double-entry bookkeeping.
- The number of accounting transactions: Cash accounting uses fewer accounts while Accrual accounting uses more accounts.
When you are about to start a new business, you must chat with your accountant to understand how each accounting method can affect your business in the long run and opt for the one that best suits your business. Although, your accountant might most likely ask you to opt for the accrual method if your business is an inventory-heavy business. Otherwise, the cash or the mixed method will do just fine.