The Basics of Cash and Accrual Accounting

September 15, 2015

A dilemma between cash and accrual accounting can pop up at any stage of running a business. Maybe you are just starting out and want to make the right choice from the start. Or maybe you are selling your business, obtaining a loan or preparing for an audit and need to switch from one accounting method to another. It’s important to understand the implications of your choice before you dive into it. As a Maryland CPA, I frequently consult local businesses on cash and accrual accounting methods, and am happy to offer some basic tips.

The Cash Accounting Basis

In cash accounting, you would recognize revenue when you receive the payment, whether it’s cold, hard cash in your hand, a check in the mail or an online money transfer. Similarly, you would recognize expenses when you actually pay the bills. In short, cash accounting is all about when money leaves or enters your business. If your paving company installed a new driveway for a client last week, but you still haven’t received the payment, you can’t record a profit just yet. So if your expenses happened in June but you didn’t collect the payment until July, June will show a loss and July will show a profit.

#1 Key Benefit: it’s simple!

With cash accounting, it’s simple and easy to keep track of your money flow. It reflects the exact amount of money in your bank account.

#1 Tax Implication

Your income isn’t taxed until you physically receive it. This allows for such arrangements as deferring one quarter’s income into the next one if you did the job but haven’t gotten paid yet.

The Accrual Accounting Basis

In accrual accounting, using the above example, you would record a profit once you send out an invoice. And you would recognize expenses typically at the same time as the profit. Therefore, if that paving job cost you $4,000 in materials and labor in June, and the customer paid $9,000 in July, you would record a $5,000 profit in June when the job was completed. To keep track of all these transactions, the accrual system uses accounts payable, accounts receivable and inventory that you won’t find in cash accounting.

#1 Key Benefit: it’s better for decision making

Although cash accounting is more precise, this precision may actually give you the wrong idea about the state of your business. For example, just because you didn’t get paid yet, doesn’t mean you should record a loss. Depending on the type of your business, you may want to see your losses and profits calculated together, so that you can better manage your expenses and make a better prognosis for the future. That’s what an accrual-based accounting system can do for you.

#1 Tax Implication

In accrual accounting, the income is taxed when it is recorded, so you may end up paying taxes on the money you haven’t yet received.

Which One to Choose?

The IRS requires some companies to use accrual accounting for tax purposes. If you “produce, purchase or sell merchandise,” you may fall into this category. In general, accrual-based accounting is the most popular of the two, because most businesses like their accounting method to reflect the actual income streams. However, because the accrual approach doesn’t provide an accurate overview of cash flow, this can result in big discrepancies between what’s on paper and what’s in the bank. Be sure to consult with your Maryland CPA to make sure you select the accounting method that makes the most sense for your specific business.

Can I Use Both?

While it can get complicated, it’s possible to use both accounting methods in your business. If you prefer cash-based accounting for tax purposes, you can still implement accrual-based accounting for the purpose of generating reports and making business decisions.

Contact Relate CPA today if you need help choosing the right accounting method for your business or want to make both of them work.