SMALL BUSINESS MANAGEMENT

Accrual Basis Accounting vs. Cash Basis Accounting

In accrual basis accounting, income is reported in the fiscal period it is earned, regardless of
when it is received. Expenses are deducted in the fiscal period they are incurred, regardless of
when they are paid. In other words, you record both revenues—accounts receivable—and
expenses—accounts payable—when they occur.

Accrual Basis Accounting vs. Cash Basis Accounting

The difference between the two types of accounting is when revenues and expenses are recorded.
In cash basis accounting, revenue is recorded when cash is received, and expenses are recorded
when they are paid, regardless of when they were invoiced. To illustrate the difference between
the two accounting methods take the example where a business sells a product and the customer
pays by credit:

Using accrual basis accounting, the revenue is recorded immediately.

Using cash basis accounting, the revenue would not be recorded until the credit payment was
received.

Similarly, if a business incurs an expense and pays by credit, in accrual accounting the expense is
recorded immediately, rather than deferred until the credit payment is received under cash basis
accounting.

Accrual basis accounting gives the most accurate picture of the financial state of your business.

The advantage of cash-based accounting is simplicity. It is much easier to manage cash flow in
real-time by merely checking the bank balance rather than having to examine accounts
receivable and accounts payable. Given that most businesses fail due to improper management of
cash flow, businesses that use accrual accounting still need to perform cash flow analysis.

Cash Basis Accounting

 Revenue is recorded when payment is received.

 Cash flow is managed in real time.

 Provides a point-in-time picture of a business's cash flow.

Accrual Basis Accounting

 Revenue is recorded immediately.

 Cash flow is managed by checking accounts receivable against accounts payable.

  Gives a more accurate picture of the longer-term state of a business.

The Advantages of Accrual Accounting

While cash-based accounting can give a point-in-time picture of the business cash flow, accrual-
based accounting offers a more accurate picture of the longer-term state of the business; revenues
and expenses are immediately recorded, allowing the business to more properly analyze trends
and manage finances.

Accrual accounting makes it easier to match revenues with expenses. For example, if as a
contractor you paid for $5,000 in construction materials for a project in December, finished the
job in the same month, but did not receive payment until the following February, using cash
accounting, your books would show a large loss for the period ending in December but a large
profit for the following period that includes February. With accrual accounting, you would book
the revenue from the job in December, the same month that you paid for the construction
materials.

Among the other advantages of using business accounting software, using an accounting
software package can greatly simplify accrual accounting.

Tax Implications of Accrual vs. Cash Accounting

Whether your business uses accrual or cash accounting can have a significant effect on taxation.
For example, if your fiscal year is the end of December and your business invoices a customer
for $10,000 in November of the current year but does not receive payment until January of the
following year, under the accrual method, the $10,000 would be included as revenue in the
current taxation year; whereas using the cash method, the $10,000 would be included in the
following year.

Which Method Should Your Business Use?

Many sole proprietorships and small businesses use cash basis accounting; however, accrual
basis accounting is the method of accounting most businesses and professionals are required to
use by law in the United States and Canada.

In general, if your business carries inventory and sells merchandise, you will be required to use
the accrual method as will any business that extends credit to customers, as cash accounting has
no facility to track customer monies owed on an account.

Most incorporated businesses use the accrual method. Public companies that trade shares on
stock exchanges are required to follow generally accepted accounting principles (GAAP), which
require accrual-based accounting, as investors want the most accurate picture possible of the
state of a company's finances. If in doubt, check with your accountant as to which method you
should use.