What Is Cash and Accrual Accounting?

This is Part 3 in our “All About Bookkeeping” series.

If you missed our first two articles check them out here:

What Is Bookkeeping and Why Do I Need Bookkeeping For My Business?

What Are Bookkeeping Debits, Credits, and Chart of Accounts?

Before we dig into the good stuff, financial statements, we want to discuss two types of reporting, cash vs accrual.

1. What Is Cash Basis Accounting/Bookkeeping?

Recognize revenue and expenses when cash comes or leaves your account.

• Basic Understanding: Recognize revenue when you receive cash in your account. Recognize expenses when cash leaves your account. Example: Deposit a check for April services in May, you would report that income in May (when deposited). Or, pay a contractor in June for work they did in May, that would be considered an expense in June (when paid).
• Accounts Receivable and Accounts Payable: Not recognized on a cash basis. So, if you were to have provided services for a client in May but it is outstanding, you will not recognize income until actually paid.
• Benefits to Cash Basis
  
  • Easier to Maintain
  • Easy to Understand
  • You have a better idea on money available to spend
  • Income not taxed until it hits the actual bank
• Downfalls to Cash Basis
  
  • Reporting may be less reliable (Ex: Big deposit in one month with a lot of expenses at a later time)
  • Less insights into invoices outstanding or bills needing to be paid

2. What Is Accrual Basis Accounting/Bookkeeping?

Recognize revenue and expenses when earned.

• Basic Understanding: Recognize revenue when it is earned, regardless of when it is received. Recognize expenses in the period they are related to, regardless of when it is paid. Example: Provide services for a client for the month of April, you would report income in April even if you do not actually receive payment until May. Or you have a contractor that did work for you in May you would record that expense in May even if you did not pay until June.
• Accounts Receivable and Accounts Payable: You will utilize to properly record income and expenses in the period they are earned. As you provide services or sell a product you will create an invoice (accounts receivable) to match that to the period in which you performed those services or sold that product. Once you are paid it will clear your outstanding invoice but the income would have already been recorded. Same thing with expenses, if you have a utility bill for a month you will enter that as a bill (accounts payable) in the month its related to. Once you pay that bill it will clear out your accounts payable.
• Benefits to Accrual Basis
  
  • More reliable reporting (Income and expenses match to the same period)
  • Clearer financial picture
• Downfalls to Accrual Basis
  • Harder to Maintain
  • Hard to Understand
  • Doesn’t match cash activity
  • Taxed on income not yet received

3. Should I Use Cash or Accrual Basis?

It Depends… You can potentially do both as well!

• There is no straight answer as to which option is best for your business. You will want to talk to your accountant. With that being said we want to outline some typical guidelines we discuss with clients.
• Cash Basis Best For:
  • Smaller Businesses
  • No Inventory
  • Service Based Businesses
• Accrual Basis Best For:
  
  • Bigger Businesses
  • Businesses w/ Inventory
  • Shareholders/Investors
  • Complex
• Hybrid/Combo
  
  • Most accounting software allows you to switch between cash and accrual accounting. So you have the ability to run on a cash basis but still track accounts receivable and accounts payable for internal purposes so you are keeping track of outstanding items.

4. Example / Walk Through

Lets put the learning into perspective!

• Facts
  • Send invoice for $10,000 for services in August
  • Receive a bill for $2,500 for contractor fees for August
  • Pay $500 for bill related to July in August
  • Receive partial cash payment of $6,000 for invoice in August and remaining  $4,000 in September
  • Pay bill for contractor in September
• Cash Basis Profit/Loss
  • July: $0
  • August: $5,500 Profit ($6,000 – $500)
  • September: $1,500 Profit ($4,000 – $2,500)
• Accrual Basis Profit/Loss:
  
  • July: $500 Loss
  • August: $7,500 Profit ($10,000 – $2,500)
  • September: $0
• Main Difference: Timing

We did this article prior to financial statements because your financial statements depend on which method you choose.

Now that we have an overall understanding of bookkeeping down, we can dig into the fun stuff in our next article, income statement and balance sheet!

This is just the start of our series, be sure to check back for future posts!

If you don’t have an accounting or tax advisor (or you need assistance with anything discussed), click here to book your complimentary strategy session with JETRO.