This post is for the non-accountants.
The folks who run a business, want to run a business, or are thinking about whether they should run a business. There are a couple of things you’ll need to know when it comes to accounting for your business, and this is the first in a series of terms you’ll need to know to get started.
Cash and accrual accounting refers to the timing of when you record (or “recognize”) revenue and expense transactions within your system. Curious about the differences and the pros and cons of each? Read more below.
Accural basis accounting users include sales in the accounting system when earned, and expenses when incurred. The use of accounts receivable (i.e. income earned but not yet received) and accounts payable (i.e. expenses incurred but not yet paid) are like placeholders in your balance sheet to reflect money that you are including in your reports even though cash hasn’t exchanged hands yet.
PRO: Using the accrual basis is the most common and most accurate way to track income and expenses, since the amounts are included as soon as the work is performed or bill is received.
CON: Since revenue isn’t automatically cash, the company can appear profitable without a sense of how much money is actually in the bank. In addition, the accrual system takes a bit more time since some transactions will have two steps: recording the revenue and expense, and a separate entry for when the cash is received or spent. Lastly, the tax impact can feel unfair, since the company is taxed on revenue earned that may or may not have been received in the same tax year.
When using the cash basis of accounting, you record income when you receive it and expenses when you pay them, regardless of when they are incurred. When using this method, you do not have accounts receivable or accounts payable accounts, since nothing is recorded until cash is involved.
PROS: Cash accounting is simpler to maintain, since this method takes the same idea as following your bank account - amounts are recognized only when you receive money or pay for an expense. Also, cash accounting provides a clearer picture as to cash flow throughout the year in a way that accrual accounting cannot.
CONS: The cash accounting method is less accurate since profitability doesn’t take into account items that have not had a cash transaction involved.
Once you choose an accounting method with the IRS, you’ll need to stick with it for subsequent tax years (unless you file a form requesting a change). Some business types require accrual accounting, so talk to your accountant to determine which type would work best in your particular situation.
DISCLAIMER: I am an accountant, not your accountant. Please speak with a professional about your specific accounting and tax needs before putting any of the aforementioned tips into practice.