I was meeting with a business owner last week who told me they were interested in moving to accrual-based accounting method. They were currently on the cash basis and their bookkeepers were inquiring if they wanted to convert over. The company was just entering their 3rd year and always prepared their financial statements and tax returns on the cash basis.
Before we go any further about the advantages and disadvantages of either method, lets first describe what the accrual and cash basis methods of accounting are.
Cash Basis Accounting –The cash basis is a method of recording accounting transactions for revenue and expenses only when the corresponding cash is received or payments are made. A business records revenue only when a customer pays for a billed product or service, and they record a payable only when it is paid by the company.
Accrual Basis Accounting – Revenues and expenses are recorded when they are incurred, regardless of when cash is exchanged.
Here is a quick example of how one transaction would be recorded differently….A commercial cleaning company cleans an office complex every week. At the end of each week, they bill the property management company. Under the cash basis, at the time of billing, nothing would be recorded (thus, if you printed a financial statement after billing, you would see no trace of the transaction). On the accrual basis, upon billing the property management company they would record an increase to both accounts receivable and revenue.
When the payment is received for services, on a cash basis you would increase cash and record the revenue. On the accrual basis, upon receiving payment you would increase cash and decrease accounts receivable. Under the accrual basis, you have already recorded the revenue upon the bill being sent.
Advantages of the Cash Basis
One of the biggest advantages of the cash basis method of accounting is that it is simple. Non-accounting/finance-oriented business owners get it – you pay cash, you incur an expense. Many small business owners might not have the need or desire to track receivables and payables.
Another big advantage of the cash basis is that you don’t need to pay taxes on revenue until it has actually been received. On the flip side, an owner can strategically plan when to pay expenses for the optimal tax benefit. Here is a quick example…An owner is staring at a net income of $100,000 on December 29th. They wish to reduce their net income so they can reduce their tax liability. The owner could pre-pay their January rent as well as pay in advance for cleaning services in January. Both of those payments would then be able to be deducted from net income.
In the example above, if the owner was using the accrual method, they would not be able to deduct either payment. Both would be classified as “prepaid expense” which is a balance sheet account and thus, not be able to be deducted from expenses.
One quick note about the above example that has always bugged me. If the owner were to take this strategy, the next year they would only have 11 months of rent and cleaning expense because they took the expense/deduction for January in the previous year. Both methods of accounting will eventually get you to the same place. The difference between the two is merely timing and control.
Advantages of Accrual Basis
The upside of the accrual basis is that it gives a more realistic idea of income and expenses during a period of time, therefore providing a long-term picture of the business that cash accounting can’t provide.
To illustrate this, let us think about an office supplier and how they might manage their business. Under the cash basis of accounting, this owner would not know the dollar value of inventory on hand, not know how much money they were owned by customers at any point in time, or know how much money they owed to vendors. They would also not be able to tell you with accuracy what their profit margins were so they couldn’t tell you if their pricing would need to be adjusted.
Why can’t a cash basis business tell what their margins are? Simply put, they are not matching their revenue with the expense. In other words, if the office supplier sells 200 staplers to a customer in May, he would not record the revenue associated with that sale until June, when he gets paid. The cost of those staplers would not be recorded until they were paid for, which may be July. If this was the owners only sale in June, they would show a margin of 100%. However, in July, the income statement would show a negative margin.
Essentially, accrual financial statements are required in order to make better business decisions.
What is required?
At a certain point, the IRS takes the decision away from the business owner about what method of accounting to use. Once a business reaches $5 million in sales per year, they must use the accrual basis.
However, prior to reaching the IRS threshold, there are two other factors that may force a small business to use the accrual basis of accounting. First, when a business gets a loan, many times a bank might force a company to use the accrual method of accounting. Even if the bank doesn’t, many times they might specify a “modified cash basis” of accounting that will force the owner to account for some items on an accrual basis.
The other factor that may force businesses over to the accrual basis is outside investors. Outside investors often want to see financial statements on an accrual basis so they can more accurately assess the business. Cash basis financial statements quite frankly, don’t paint an accurate picture of a companies revenues or expenses.
Best of Both Worlds
There is nothing out there that says your method of accounting for your internal records can’t be different than your tax return. For instance, you can account for your records internally using the accrual method and then your CPA can convert them to cash basis at year-end. This is actually quite easy to do if the recordkeeping is good and gives the business owner some of the advantages of both methods.
Hopefully, you have enjoyed this quick primer on the cash and accrual methods of accounting. As mainly a financial accountant, my opinion slants heavily towards to the accrual method. However, I also understand the tax flexibility that the cash basis of accounting affords a small business owner.
Krieger Analytics is a unique accounting practice that is looking to provide financial clarity for the business owner so they can accomplish their goals. We aren’t the typical accountant as we want to provide a high, more comprehensive level of service to you. We help you understand your past results and plan more for the future. Unlike most accountants, I am also a small business owner so I understand the issues you are dealing with. If you would like to discuss your business and see if we may be the right solution, contact us now.