Cash Basis Accounting vs. Accrual Basis Accounting
As a business owner, do you know the best accounting practices for your company? Do you understand the difference between cash basis accounting and accrual basis accounting? If you are starting or running a small business, you need a reliable accounting method to use as a framework for your financial statements.
Cash basis accounting records transactions when cash is exchanged as revenue or expense. Accrual-basis accounting records transactions when the revenue or expense is generated, even if the cash has yet to be received or paid. So, how do you know which one is right for your business?
WHAT IS CASH BASIS ACCOUNTING?
The cash basis accounting method records transactions when cash changes hands. It means that revenue is only recognized when you receive payment, and expenses are only recognized when you pay them. This method is easier to keep track of since you only need to track cash inflows and outflows. For example, if a business sells $10,000 worth of farm equipment, that amount is recorded in the books when the customer submits payment.
GROSS RECEIPTS TEST
According to IRS regulations, any corporation or partnership, other than a tax shelter, that has average annual gross receipts for the prior three tax years of $27 million or less (indexed for inflation) can use the cash method of accounting.
EXCLUDED ENTITIES
Before the Tax Cuts and Jobs Act, some entities were excluded from using the cash basis method. However, the TCJA expanded the rule to include all entities that pass the gross receipts test (under $27 million). Serviced-based businesses (lawyers, engineers, architects, accounting firms, etc.) can still file on a cash basis even if they are over the gross receipts threshold, regardless of entity status.
ADVANTAGES OF CASH BASIS ACCOUNTING
- Simple to use and accounts for cash paid or received
- Not paying taxes on uncollected revenue (receivables)
- Enables easy tracking of the business’s cash flow
DISADVANTAGES OF CASH BASIS ACCOUNTING
- Not accepted by GAAP (Generally Accepted Accounting Principles)
- Doesn’t report accounts payables (liabilities), which can make it seem like the company is generating profits when they really have future expenses to pay
- Provides a day-to-day view of finances, which can be unreliable when making long-term management decisions
WHAT IS ACCRUAL BASIS ACCOUNTING?
Accrual basis accounting is a more complex accounting method that records transactions when they occur, regardless of when cash changes hands. This method requires the accurate tracking of accounts receivable and accounts payable. The accounting method is best for businesses with more complex financial transactions. It offers a more accurate financial picture by lessening the impact of timing differences between revenue and expense.
For example, if a business sells $10,000 worth of equipment, the revenue is booked the day they made the sale, even though they may not receive funds for 30 or 60 days. Large businesses with average gross receipts of greater than $27 million for the prior three tax years must use accrual basis accounting to match their financial records with the expenses and revenue of a reporting period.
ADVANTAGES OF ACCRUAL BASIS ACCOUNTING
- Provides a complete picture of your business’s finances and performance
- Enables business owners to make financial decisions with accurate information
DISADVANTAGES OF ACCRUAL BASIS ACCOUNTING
- Companies may look profitable in the long term while overlooking a short time cash shortage
- Accounting for prepaid revenue and unearned revenue can be complicated
THE KEY DIFFERENCES BETWEEN CASH-BASIS AND ACCRUAL-BASIS ACCOUNTING
The key difference between cash basis and accrual basis accounting is the timing of the period when expenses and revenue are recorded and recognized. The cash basis accounting recognizes expenses and income upon exchange. Accrual basis accounting focuses on the anticipated costs and revenue.
WHICH ACCOUNTING METHOD IS BEST FOR MY BUSINESS?
Cash-based accounting is suitable for your business if you have simple financial transactions and meet the gross receipts test. Accrual basis accounting provides a more accurate picture of a company’s financial health for complex financial transactions.
If you are unsure which is best for your business, we’re happy to help. Contact us with questions!
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