When small businesses choose online bookkeeping and virtual accounting services, they get to enjoy the peace of mind that comes from putting their books in the hands of experts. That being said, it's still a good idea for business owners to understand the basics of various accounting methods.
The question of accrual vs. cash accounting is actually one of the first accounting decisions any business must make. In fact, choosing the most appropriate small business accounting method can help a company save money and simplify their bookkeeping procedures.It All Comes Down to Timing
If a company uses cash-basis accounting, each transaction is recorded at the time of payment. On the other hand, if a company uses accrual-basis accounting, each transaction is recorded when it takes place. If transactions are paid off on the spot, in cash, the two methods will work exactly the same. However, if a purchase is paid on credit or with a check, the two accounting systems will diverge.
How does this work exactly?
Most entrepreneurs favor this system because it’s a simplified bookkeeping process. It’s easy to keep tabs on cash as it moves in and out of your bank account since there’s no need to record accounts receivable or accounts payable.
Let’s take a look at cash basis accounting action using the following example:
Your accountant will not record any transactions in January since there is no cash coming into the business or any funds leaving. However, in February, both your revenue and cash balance will increase by $5,000 once your customer sends payment. Expenses are handled in a similar fashion: They are only recorded when cash goes out of your business, in March.
Thinking in terms of cash is not necessarily a bad thing since cash is after all the lifeblood of every business. However, a major drawback of cash basis accounting is that it can produce an inaccurate overall view of your finances since revenue and expenses may not always line up due to the timing of the transactions.
Going back to the example above, in February, you might think you are experiencing a high cash flow month. However, this is misleading since you have not yet accounted for outgoing expenses associated with this project of $2,000 which will be incurred in March.
Effect on Taxes
Under the cash method, your small business must pay income tax on any revenue until the minute it’s received in your back account. For example, any customer payments you receive in 2019 for projects completed in the previous year would be recorded as income for the 2019 tax year. This reduces your 2018 net income (assuming projects expenses were paid in 2018), and as a result, your tax payments for the 2018 tax year would be lower.
Under this approach, transactions are recorded as they are earned or incurred, regardless of the timing of cash flows (in or out of the business).
Let’s use the same example:
In January, your profit and loss statement will show revenues of $5,000 and expenses of $2,000 for a gross profit of $3,000. On the balance sheet, accounts receivable will increase by $5,000 and accounts payable will increase by $2,000.
Once the customer pays the invoice in February, your accountant will reduce accounts receivable by $5,000 and increase cash by the same amount. In March, both your cash balance and accounts payable will decrease by $2,000 when you pay your vendors.
This example illustrates why the accrual method is so popular with larger organizations and with accountants because it gives you a much clearer view of how your business is performing. When you look at your profit and loss statement in January, you have a report showing revenue and costs that line up. In other words, you can clearly see how much money you earned, how much it cost to generate this revenue and how much you have left.
However, on the flip side, accrual accounting does a poor job of tracking cash flows. Under this small business accounting method, the amount of cash coming in from your sales may not always match up with the revenues you’re reporting on your profit and loss statement. For example, in January, you’ve recorded $3,000 in gross profit but your bank account will not reflect this because your customers have not yet paid their invoices, nor have you paid your vendors for costs associated with the project.
This therefore means that unless you are closely monitoring your cash flow, you might have difficulty meeting upcoming expenses (such as payroll), servicing debt and reinvesting in your company. In addition, creating regular cash flow projections is also vital because it helps you to plan for future growth and anticipate potential pitfalls in your cash position that need your attention. But, more on this point later.
Effect on Taxes
Under accrual accounting, revenue is recognized and recorded at the time a transaction occurs (e.g. when a product ships or a service is provided). And businesses are required to pay taxes on revenue booked for the current tax year. This could result in issues paying your tax bill if you have a lot of late-paying customers (high accounts receivable).
It is also important to note that in the case of accrual accounting, if you receive an advance payment in in the current tax for services that you agree to perform by the end of the following year, you can defer tax liability until the next tax year. The IRS has issued guidelines on how to report advance payment for services under accrual accounting method.
Disadvantage of Accrual Accounting
For most companies, the biggest drawback to the accrual method is its relative complexity. With the accrual method, it's necessary to record each transaction as it occurs, but it's also necessary to keep track of when each transaction is actually paid off. The bookkeeping burden at least doubles.
However, the good news is that instead of hiring in-house, you can choose online bookkeeping services to save time and money.
Considering the above benefits and drawbacks of each method, which should you choose? The answer often boils down to the size of your business and your comfortability with small business accounting processes.
For most small start-ups, cash-basis accounting proves advantageous due to its simplicity. However, given how many transactions are handled on credit, the accrual accounting method is considered necessary by many companies. In fact, corporations with annual sales exceeding $5 million and all business with inventory are required to use the accrual system.
It is important to note that you’ll need to select an accounting method when you file your first tax return and use it consistently going forward. However, this isn’t as set in stone as it seems. For example, as your business grows, your CPA might advise you to switch to accrual accounting. In this case, you can request permission from the IRS to change accounting methods by completing IRS Form 3115. Failure to do so can result in penalties.
Bookkeeping Needs Under Accrual Accounting
As mentioned, above, the relative complexity of accrual accounting necessitates the understanding of more bookkeeping especially as it regards managing payables and receivables, and creating cash flow forecasts. Let’s take a look at each of these in turn.
There is a potential risk of having a large amount of accounts receivable because, by definition, the success of the concept depends entirely on the reliability of the debtors. It’s also an important responsibility of the company to follow up with outstanding invoices or payments. An “aging” account receivable is dangerous, as it is unlikely to be paid back in full.
Here are some steps you can take to better manage your accounts receivable:
Managing accounts payable is also a key part of accrual accounting that involves vendor management.
Here are some tips to better manage cash outflows in your business:
Cash Flow Forecasting
As mentioned above, managing your cash flow is more important than ever if you select the accrual method for their your business. This also means that putting together cash flow projections on a regular basis should be a top priority to ensure the long-term viability of your business. Looking at past performance is an excellent starting point. However, be sure to account for anticipated changes as your business evolves.
At Ignite Spot, when we do a cash flow forecast for your company, we will review all of the variables that affect your cash in and cash out positions. The template we create for your business will be custom built to you and your needs. Once it's created, we can update it and meet with you each week or month depending on your needs.
As you can see, there are many moving parts when it comes to choosing the right accounting method. The cash basis is straightforward but not always ideal for larger organizations who need a more accurate view of their financial performance. That said, accrual accounting requires additional time and effort to manage the bookkeeping process.
However, taking advantage of online bookkeeping services to help you manage these tasks will allow you to focus on what you do best -- building better client relationships and learning new ways to grow your business.