The Different Between Cash Basis and Accrual Basis
Written by Eddy Hood
The question of accrual vs. cash accounting is one of the first accounting decisions any business must make. At Ignite Spot, we aim to deliver the outsourced accounting services that best fit each individual business. To that end, our firm works with all of our clients to assess their individual situations and inform them of the best accounting and bookkeeping options to maximize profits and meet their goals. There's no need for our clients to learn all the ins and outs of accounting. However, for any small business owner, it can prove helpful to know a little something about the difference between cash-basis and accrual-basis accounting.
In essence, the difference between cash-basis and accrual-basis systems is a matter of 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.
As an example, suppose that a company buys new software. They order the software online, provide their credit card information, and download the product on December 1st. If the company is using the accrual method of accounting, their books will show that they purchased new software on December 1st. Supposing that the company used a credit card to pay for the software, the payment may actually clear one month later, on January 1st. Therefore, if they use the cash-basis accounting method, the transaction will be recorded as having taken place on January 1st.
In the end, both accounting systems reflect the sale accurately. However, one system immediately reflects each purchase, while the other reflects the day-to-day flow of cash. When most businesses consider the question of accrual vs. cash accounting, they find that the accrual method delivers a better picture of their overall financial picture. In the example of the software purchase, the company's accounts during the month of December will already reflect their purchase if they use the accrual method. Even though the purchase would go unpaid until the first of the following month, the accrual method would give the better picture of their available funds and overall financial standing.
The example of the software purchase also illustrates a secondary difference between the two accounting systems. The transaction takes place in December but the payment takes place in January. Therefore, the two accounting methods would report the transaction as having taken place in different years. As a result, which accounting method a company chooses can also affect their annual tax reporting.
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. However, at Ignite Spot, we know that each company is different. For some small start-ups, cash-basis accounting actually proves advantageous.
To learn more about the two systems and how Ignite Spot can help you navigate them, visit these links: