The distinction between cash and accrual accounting boils down to one crucial factor: TIMING. Timing is pivotal in life, and this certainly holds true for accounting. Let’s explore how it impacts the way you account for your business’s finances.

The Simplicity of Cash Basis Accounting

Cash basis accounting is straightforward. When evaluating financial statements from a previous year, the revenue on the income statement represents the actual cash received during that year, and the expenses represent the money spent within the same timeframe. It’s simply cash in and cash out. 

The Complexity of Accrual Accounting

Accrual accounting, on the other hand, is much more intricate. It focuses on recording revenue and expenses when the economic activity occurs, regardless of when the actual cash transaction happens. Revenue on the income statement represents the amount earned during the period (regardless of whether or not it was received) and expenses are the amounts incurred that generated the revenue (regardless of whether or not they were paid). 

Cash vs Accrual: A Comparative Analysis

Accrual accounting offers a more accurate reflection of a company’s financial performance, showing how much the business truly earned within a specific period. Meanwhile, cash basis accounting, while simpler to understand, may not always reflect the company’s accurate earnings during the period.

Choosing the Right Method for Your Business

The choice between cash and accrual accounting largely depends on your business needs. Consider which information is most relevant for your company’s decision-making processes.

The advantage of cash basis accounting is the accounting is more simple, and it’s easier to understand. It’s often used by smaller businesses, particularly those with simple operations and low transaction volumes. We believe that cash basis is fine for small businesses that are closely held and don’t have external reporting requirements.

Accrual basis accounting is required if the books must be in compliance with Generally Accepted Accounting Principles (GAAP). Accrual basis is recommended (and usually required) in the following situations:

• • • You plan to raise capital from outside investors. They’ll be interested in seeing the amount that you earned over the period, not just the cash that came in. To be sure, they’ll want to see your cash flow as well, but that doesn’t mean you need to keep your books on a cash basis.
    • You have any loan covenants. Lenders generally require GAAP based financials as a condition of the loan.
    • You need an audit. We’re not talking about an IRS audit here, but a financial statement audit that may be required by lenders, investors, or a regulatory body. Audits require GAAP based financial statements which must be accrual basis.
    • Your company is growing. Larger companies almost always report their financials on an accrual basis. So if you are small but don’t plan on staying that way, it’s advisable to use accrual basis from the start.

Tax Returns and Accounting Methods: Busting the Myths

Contrary to popular belief, tax returns and financial records don’t have to use the same accounting method. It’s possible, and sometimes beneficial, to use different methods for each. It’s common to use accrual based accounting for book purposes to get a better picture of a company’s economics, and cash basis for tax purposes to take advantage of certain tax savings.It doesn’t mean keeping 2 sets of books. You would just keep your books on an accrual basis and make adjustments for your tax returns based on the amount of cash flow.

A simple cash vs accrual basis example

Here is a simple example to illustrate the difference between cash and accrual basis financial statements. The difference relates to when revenue and expenses are recognized on the income statement. 

An architect firm works on a project for a price of $30,000. All of the work is performed in May, the invoice is sent and the client pays in June. A cash basis income statement would show the revenue in June (when the cash was received), and accrual basis would show the revenue on the May income statement (when the work was done and the revenue was earned).

Let’s say our architect incurs expenses to generate that revenue including salaries, materials and other expenses totaling $10,000 and they’re paid in June. For accrual basis, accounting expenses are recognized when the company incurred them in May, even if the company has not yet paid for them. Cash accounting recognizes the expense when the money goes out the door, in June.

The accrual-based profit would show $20,000 in May where cash basis would show the profit in June. It’s typically more meaningful to see an income statement with the amount earned during the period. Managing cash flow is also important (critical even), but cash can be monitored with a separate cash flow statement. (See our video on cash flow statements.)

In the real world, it usually gets a little more complex than that because revenue and expenses can be scattered over several months and figuring out which accounting period they relate to can be a challenge.

The main advantage of accrual accounting is that it provides a more accurate picture of a company’s financial performance – how much the company actually earned during the period. It gives a more complete view of the profitability of a company’s operations. In most cases, accrual is a more meaningful measure than cash basis so it’s worth the effort.

Conclusion: Making the Right Choice with Juna Financial Solutions

At Juna, we’ve transitioned numerous clients from cash to accrual accounting. If you need guidance on choosing the best method for your business, or help with the transition process, get in touch with us for a complimentary consultation at info@junafinancial.com.