The most commonly used basis by small businesses is the cash basis method of accounting. Most small businesses (with sales of less than $5 million per year) are free to adopt either the cash or accrual accounting method. The Internal Revenue Service (IRS), in the first year of business, gives a choice of reporting income, expense, and profit on a cash or accrual basis.
So what is the main difference between the accrual and cash basis of accounting and which is more acceptable?
The main difference is the timing of when revenue and expenses are recognized. Under the cash basis of accounting, revenue is recognized when received and expenses are recorded when paid. Whereas, under the accrual basis of accounting, revenue is recognized when earned and expenses when incurred.
Businesses are required to use the accrual method of accounting if:
- Sales of the business is more than $5 million per year
- The Business has inventory sold the public with gross receipts of over $1 million per year.
It is important to note that whichever method a business choose to use, either one gives only a partial picture of the financial status of your business.
Advantages and Disadvantages
Accrual method – Cash flows may not be positive as the financials will show a high sales amount, but not cash in bank, as payments have not been received by customers. However, under this method, the ‘full picture’ of the transactions are recorded.
Cash method – Cash in the business is readily recognized under this method. However, revenue could fluctuate from one month to the other, and having a large amount of cash in bank could just be a result have getting paid by credit customers in that month and the following month, could have slow sales and significant decreased in revenue and cash.
Regardless of which method a business uses, management must garner a thorough understanding of its business operation and financial health. There are many variables that contributes to a successful and profitable business, including the financial capabilities.
Converting from Accrual to Cash Basis
There are times, for example in the preparation of a tax return when a business may report its books on the accrual basis of accounting, but want to report its results under the cash basis of accounting. It is pertinent that the changes to convert from accrual to cash for tax preparation purposes should not be entered into the accounting records of the business, unless the business is changing the basis of accounting to the cash basis permanently.
Main Accounts for Converting:
Accounts Receivable – Exclude current receivables from Income for cash not received in the period. Include receivables from the prior period where cash has been received in the current period for prior period sales.
Accounts payable – Exclude expenses for any payable that were not actually paid in cash during the period. Include payables from the prior period where cash has been paid in the current period for prior period expenses.
Your conversion should be done external to the accounting system, for example in an excel spreadsheet. Additionally, while the IRS allows for the use of the cash basis method for tax reporting purposes, it is limited to smaller organizations that do not report any inventory at the end of their calendar or fiscal years.
We hope this blog provided useful and valuable insight on the difference between the cash and accrual basis of accounting. For more information and insight email us at [email protected] or contact us at (301) 974-4568.