Is your business on Cash Basis or Accrual Accounting? It’s accounting jargon that small business owners don’t understand. You have no idea what this means, you just want to run your business. Don’t worry, we are going to demystify what the difference is between Cash Basis vs Accrual Accounting so you will know what’s better for you and your business.
Types of Accounting
There are three (3) common types of accounting methods:
- Cash Basis,
- Accrual Accounting,
- GAAP (Generally Accepted Accounting Principals)
These accounting methods tell you how to report your money when it’s coming in or going out of your business. We are going to go over them below.
Cash Basis Accounting
Cash Basis Accounting (also referred to as Cash Basis) is when you report the income (money coming in) at the moment the money is actually received, and you report expenses (money going out) when payments are actually spent.
Accrual-Basis Accounting (also referred to as the “Accrual Method”, or simply “Accrual”) is when you report your income when the money is earned (not necessarily received) and you report the expenses when they’re incurred (not actually when they are spent).
I know that Cash and Accrual sounds like the same thing, but they’re not. I am going to give you a few examples so it’s easier to understand.
Examples – Cash Basis
Cash Basis Example – Income:
Romeo (that’s me) owns a CPA firm. A new client paid me $3,000 in December 2021 to help them with an IRS audit. The Audit started in December 2021 but gets wrapped up in March of 2022.
If my business is on the Cash Basis, I must report the income in December of 2021, since that’s when I got the Cash, even though I don’t finish the job until next March. That means $3,000 of income goes up on my Profit and Loss statement in December 2021.
Cash Basis Example – Expenses:
In August of 2021 Josh purchases a point of sale (POS) system from Toast Inc. for his new restaurant. They give him the POS register for free but tell him that to use it he must pay a monthly software subscription of $210 a month. They require he pays the entire subscription cost of $2,520 ($210 x 12months) at once. Josh’s business is on the Cash Basis, so he will expense the entire $2,520 in August. That means $2,520 of expense is reported on his Profit and Loss statement in August of 2021.
Pretty simple. Money hits my bank account (comes in), so my income goes up. When money leaves (expensed), my expenses go up. Now let’s look at Accrual Accounting examples.
Examples – Accrual Accounting
Accrual Example – Income:
In my example above, I helped a new client with an IRS Audit that didn’t get wrapped up until March of 2022. If my firm reported its accounting using the Accrual Method, I would not recognize the income on my profit and loss statement until March of 2022. Even though I received the payment in December of 2021.
In other words, until I finish the service that I’m paid for, I can’t recognize the income. Let me know show you another example using monthly subscriptions as income.
Accrual Example – Subscription Income:
Matt owns a software company. He sells monthly subscriptions for his online software for $30 a month. If you pay for one year upfront (annually), he will give you a $5 monthly discount. That means his customers can make a onetime payment of $300 ($25 x 12 months), instead of paying $360 ($30 x 12 months) over 12 months.
Steve, a customer, decides to subscribe annually to Matt’s software on November 1st, 2021. Since Matt uses Accrual Accounting, he will have to record $25 of income in November, and recognize another $25 every month, until October of 2022.
This is how Matt’s income looks on his profit and loss statement, accrual basis vs cash basis:
Accrual Example – Accounts Receivable
Let’s say John owns a law firm that does contract work. He prepares a legal contract for Steve and bill him in December of 2021. Steve doesn’t send John a payment until February 2022. Guess what? John has to report the income in December of 2021 (and pay taxes on it). This is even though he doesn’t get paid until a few months later.
You will hear the term Accounts Receivable (or “A/R” for short) when dealing with Accrual Accounting. Your accounts receivable (money you’re expected to collect) goes up and your income goes up at the same time.
This is the #1 reason small business don’t like to use Accrual Accounting. Because they have to report income and pay tax on it, even though they haven’t receive the money yet.
Accrual Example – Expenses:
Josh’s Register Subscription Expense: In the example above Josh paid Toast $2,520 for a year of their software in August of 2021. If Josh’s business is on the Accrual basis, he will only be able to expense $210 a month, each month, until his subscription is finished the following July of 2022.
Accrual Example – Prepaid Expenses:
Let’s say Mark’s business is on the Accrual Method and pays his January 2022 rent on December 27th, 2021. Guess what? If Mark is an Accrual Accounting, he can’t expense his rent payment until January 1st, 2022.
What is GAAP Accounting?
GAAP stands for Generally Accepted Accounting Principles. It’s accounting standards that all CPAs need to follow when they are reporting financial statements.
Certain 3rd party institutions will ask for the financials to be on GAAP. Examples of 3rd party institutions that request GAAP financials are:
- Banks, when you’re getting a big loan
- Government, when you’re applying for grants
- Venture Capital (VC), when you’re raising investment money
There are a lot of rules and regulations that need to be followed by CPAs for GAAP accounting. Too much to cover in this article. Just keep in mind, if someone asks you for GAAP accounting, it will be more expensive than regular accounting.
Which is Better?
Accounting for the Accrual Method is much more complicated than Cash-Basis accounting. Also, as mentioned earlier, if you’re on Accrual, you have to report income before you get paid. That’s why most small businesses use the Cash-Basis when they start out.
Additionally, there are more tax planning strategies when you’re on the Cash-Basis (we wrote an article about it here).
Regardless, there are some cases that you will have to report your accounting on accrual. For instance, if your business holds inventory or product. Also if you’re are in construction. In these cases you will need to use Accrual Accounting to calculate your company’s gross margins (sales price minus cost of product or job).
As mentioned before, if you’re getting VC funding or are getting big loans, you will be required to use Accrual Accounting. Best thing for you to do is check with your CPA or bookkeeper to figure out what is best for you and the industry that your business is in.