Business Accounting Basics: Cash Basis vs. Accrual Basis – an Indianapolis Accountant Explains Both
Do you know the difference between cash basis and accrual basis when it refers to business accounting methods or financial statements? Which one is better to use and which one should you use? Not sure? Let’s find out.
You’ve probably heard the terms ‘cash and accrual’ before but what do they really mean? Let’s start with the cash basis method of accounting. This method, simply put, means that you record income when it is actually received, not when it’s earned and you record expense when they are paid, not when they are incurred. Let’s say you performed a service, such as mowed a customer’s lawn and mailed them an invoice. You would record the customer’s payment as income, not the invoice. It’s the same with your expenses; record them when you pay them, not when you receive the bill. Here in the US, most individuals are considered cash basis taxpayers but there are four types of taxpayers that are not eligible to use the cash basis if their gross receipts are too high and they don’t meet other exceptions.
- C Corporations,
- Partnerships with at least one C Corporation partner,
- Tax shelters and taxpayers required to keep inventory such as retail,
- Wholesale or manufacturers
The reason behind this last exception has to do with the upfront cost of acquiring or manufacturing the inventory for resale and that you cannot expense these costs until the inventory is sold. Therefore, inventory, prior to its sale, is an asset, not an expense.
Most of my small to midsized service based business clients are on a cash basis and this is good tax strategy, in my opinion. Why pay income tax on revenue earned but not yet paid by your client or customer? And, at year end, escalating expenses into the current year is a great way to shift expenses from next year to this year to reduce this year’s profits. This isn’t always the answer but certainly worth looking at if you’ve had a very profitable year.
Now let’s look at the accrual basis of business accounting. This method records income when it’s earned not when it’s paid by your customer. Let’s look at the previous example, you mowed a customer’s lawn and mailed them an invoice. When you generate an invoice to your client, this amount will appear on your Profit and Loss in the month it was invoiced as income, not when you received the payment. It’s the same when recording expenses; when they are incurred, not when you actually pay them. If you receive a bill from your printing company in January but pay the bill in February, the expense will appear on your January Profit and Loss.
Sound pretty easy? It really is but, as in virtually all accounting and tax law, there are exceptions, ifs ands & buts so if you’re not sure about a certain transaction, make sure to ask your accountant for guidance.
And here’s one more little tip: when I’m working with a business client and analyzing their financial statements, I look at the accrual based statement when analyzing one accounting period over another because this is the best indicator of business performance. However, when I’m analyzing the financial statements for tax planning purposes for a cash basis taxpayer, I use the cash basis financial statement because this most closely matches what the taxes will be based on and, if you’re a QuickBooks user, you can easily toggle between the two methods of reporting in the customize report feature.