There are two basis of accounting methods: cash basis and accrual basis. Every time I bring these two words up, no one knows what I'm talking about, so I don't expect you to know them either. Actually, it's probably why you are here reading this post.
Part of doing the accounting for your business is knowing which method you are using.
These methods are different because they state when a transaction is recorded in your business.
For the cash basis of accounting, a transaction is recorded when cash is exchanged.
For the accrual basis of accounting, a transaction is recorded when revenue is earned or an expense is consumed.
In this article, I am going to dive into multiple examples of the two methods, as well as when you should be using a specific method in your business.
What is Accrual Accounting?
Accrual accounting, or the accrual basis of accounting, is when you record the transactions in your business when the revenue is earned or the expenses are incurred.
For example, if you have ads on your website, in April you earn $487 from those ads, but you don't actually receive the money in your bank account until June, you would still recognize the revenue in April in your business books, even though cash isn't received until June.
Or you buy your Tailwind subscription for a whole year. Using the accrual basis of accounting, you would put the cost of the Tailwind subscription into a Prepaid expense account, then each month you would expense the monthly cost of the subscription.
The accrual basis of accounting provides a realistic view of your business, but it doesn't give you a real sense of what your cash flow is or your business profitability.
The accrual basis of accounting is preferred by accounting professionals because it does give you the long term visibility in your business so that you can see when you are expecting to receive money in your business and what expenses are coming up to be paid. But at the same time, it doesn't allow you to really see the true amount of cash and profit in your business at a given moment in time.
What is Cash Accounting?
The cash basis of accounting recognizes your revenue and expenses when cash is exchanged.
When you look at the same examples above, for the ads, you wouldn't recognize the ad income until the cash is received in June.
For the Tailwind subscription, you would recognize the full year's cost on the date that you paid your subscription.
If you have a client who is paying you in monthly installments, you wouldn't recognize the revenue until you received the money in your bank account each month.
The cash basis of accounting shows exactly how much cash you have available at any given moment in time.
The cash basis of accounting is the method that most online business owners use for their business because it's simply easier to utilize.
The downside to using the cash basis of accounting is that it's hard to forecast when you are going to receive money in your business or what expenses are coming up (unless you keep detailed spreadsheets of the income and expenses you have in your business).
Which Accounting Method Should You Use?
There really isn't a right or wrong answer for which method you should use in your business.
If you have an accountant set up your business from the beginning, then you will most likely be using the accrual basis of accounting method.
If you just set up everything in your business, then you will most likely be using the cash basis of accounting because that is what is easier for you.
The only time you have to use a specific method is when you are accounting for taxes due. It doesn't matter what type of taxes we are talking about here: sales tax, income tax, or any other type of tax your business may owe.
You must use the accrual basis of accounting for accounting for taxes. But you can still use the cash basis of accounting for everything else in your business.
The reason you have to use the accrual basis of accounting for tax purposes is because you report the tax due based on when you accrued it in your business.
For example, for sales tax, you made a sale in your business and charged your customer sales tax. This sale happened on April 30. But the customer didn't pay you until May 2. The sales tax is due on the April sales tax return, not the May return.
If your business makes more than $5 million in a year, then the IRS requires that you use the accrual basis of accounting. If you make less than $5 million a year, then the IRS permits you to use the cash basis of accounting.
If you keep a physical inventory of products, then you also must use the accrual method of accounting.
Most online business owners do not fall under either of these two categories, therefore, you can choose which method you want to use. This is also why most online business owners use the cash basis of accounting.
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Example Comparison of Cash vs Accrual Basis of Accounting
Let's look at a real example of the comparison of the two methods to get a clearer picture of what happens when you use one method versus the other.
Last month, your business had the following transactions:
- You booked a new client in your business and she opted for the monthly payment plan. The total cost of the plan is $5,000. She paid $1,500 upon signing up as a client and will pay $700 a month for the next 5 months.
- You paid your monthly telephone & internet bill for $150.
- You paid your yearly fee to Tailwind for $120.
- You paid your monthly fee to your email service provider for $17.
- You received $1,500 in cash from a client you invoiced last month.
- You sent an invoice to a client whose project you just finished for $2,500, but you didn't receive payment yet.
Using the Cash Basis of Accounting, you would recognize the following transactions for your business:
- You booked a new client in your business and she opted for the monthly payment plan. The total cost of the plan is $5,000. She paid $1,500 upon signing up as a client and will pay $700 a month for the next 5 months. - $1,500 would be recognized when it's received and each $700 payment would be recognized when it's received.
- You paid your monthly telephone & internet bill for $150. - The whole payment would recognized on the day it's paid.
- You paid your yearly fee to Tailwind for $120. - The whole payment would recognized on the day it's paid.
- You paid your monthly fee to your email service provider for $17. - The whole payment would recognized on the day it's paid.
- You received $1,500 in cash from a client you invoiced last month. - The $1,500 would be recognized when received.
- You sent an invoice to a client whose project you just finished for $2,500, but you didn't receive payment yet. - Nothing would be recognized because cash wasn't exchanged.
Total income: $3,000
Total expenses: $287
Net Profit: $2,713
Using the Accrual Basis of Accounting, you would recognize the following transactions for your business:
- You booked a new client in your business and she opted for the monthly payment plan. The total cost of the plan is $5,000. She paid $1,500 upon signing up as a client and will pay $700 a month for the next 5 months. - The whole $5,000 would be recognized, but $1,500 would be recognized as revenue and $3,500 as revenue earned but not yet received.
- You paid your monthly telephone & internet bill for $150. - The whole payment would recognized on the day it's paid.
- You paid your yearly fee to Tailwind for $120. - The whole payment would recognized on the day it's paid as a prepaid expense and only $10 would be recognized as an expense.
- You paid your monthly fee to your email service provider for $17. - The whole payment would recognized on the day it's paid.
- You received $1,500 in cash from a client you invoiced last month. - You already recognized this payment last month.
- You sent an invoice to a client whose project you just finished for $2,500, but you didn't receive payment yet. - The $2,500 would be recognized on the day it's invoiced.
Total income: $4,000
Total expenses: $177
Net Profit: $3,823
Benefits of Cash Basis of Accounting
Are there any benefits to using the cash basis of accounting?
It's true that many small businesses opt to use the cash basis of accounting because it's a really simple method to use.
It's simple because it is just showing what is happening in your business basically on a minute by minute basis.
You also do not need to worry about tracking any receivables or payables for your business either (but as a business owner, I sure hope you are keeping track of your receivables and payables!).
This method also makes it easy to track your cash flow any given point in your business. You always know the exact cash flow you have in your business with this method because it's based on cash in and cash out of your business.
You also will not pay income tax on your profit until it is actually received money.
You can easily have an immediate view of what your business's financial situation looks like and how much cash you have available at any point in time.
Benefits of Accrual Basis of Accounting
Are there any benefits to using the accrual basis of accounting?
The accrual basis of accounting gives you a long term picture of what is happening in your business because you recognize your receivables and payables. You have a big picture of what money is coming into your business and when it is coming in.
This method allows you to plan more in the future because you have an outlook of what the financial picture of your business actually looks like. This allows you to forecast future growth and make even smarter business decisions.
But there is a drawback with the accrual basis of accounting - it does not allow you to properly track your cash flow and easily know what is in the bank. The amount of revenue that is reflected in your books is usually much higher than what is in your bank account.
Which Method is Better?
Both methods have their pluses and minuses. At the end of the day, it comes down to which option works best for your business (given that you haven't met the IRS limits to be required to use the accrual basis of accounting).
You could ask several different people and you will not get the same answer across the board which method is better.
You have to choose for yourself and your business which method is better to use.
Choosing Your Accounting Method for Your Business
The accrual method is required for sales tax purposes. The accrual method is required by the IRS when you meet the limits.
The accrual method is preferred in the accounting community. It also more accurately reflects the financial situation of your business.
The cash basis method allows you know exactly how and when the cash is being used in your business.
The accrual method helps you see the big picture for when you can expect cash to be coming in and going out in your business.
If you really are unsure which method to be using in your business, then please contact an accounting professional and sit down to have a chat about your business and your business's accounting needs.
You want to make sure your business's bookkeeping and accounting needs are taken care of on a regular basis and kept up to date. Don't wait until it's time to file your taxes to get your bookkeeping up to date.
Which basis of accounting are you using in your business?
Next Read: Making Your Business Recordkeeping Easy
