Cash Basis Accounting Vs. Accrual Accounting
Cash basis accounting is a billing method where accounts receivables and accounts payables are not used. In other words, the revenue is considered and recorded the moment payment is made, and not when it is billed. This method only looks at the moment cash changes hands.
On the other hand, accrual accounting refers to the method of considering and recording revenue when it is billed. For instance, if a sum is billed but not yet paid, it would be considered in the accounts receivable records.
This creates two different ways of assessing revenue at any given time, and each system has its pros and cons.
How It Works
To understand how both methods work, take a look at the example below.
You sent an invoice of $6,000 for an audio editing project this month. You:
- Got a payable invoice of $500 from the studio
- Paid $90 in software charges for an invoice from last month
- Received $3,000 for a project completed last month
Cash basis accounting involves subtracting the total paid cash from the total cash received to calculate profit. Accordingly, the profit is $1,910 ($3,000 - $90).
On the other hand, accrual accounting profit is calculated by subtracting the total estimated liabilities from the total estimated assets. Hence, the profit comes to $5,500 ($6,000 - $500).
The Cases For Using Cash Basis Accounting
Take a look at the following list of reasons why micro enterprises and freelancers prefer cash accounting.
Convenience And Simplicity
Cash accounting methods are largely easier to use and understand. It is convenient to track transactions and view a true snapshot of revenue at any given time. This is especially useful for small enterprises that generate cash transactions without any sizable inventory. Moreover, this method is easy to execute unlike complex accrual records.
Clear Assessment Of Cash Flow
If your customers pay immediately after a service is rendered, it is better to keep cash based payment records. It gives you a clear idea about the cash you have in hand without hiring an accountant. Also, this type of accounting gives a clear idea about the real-time financial status of the business.
Lower Tax
When a business owner uses cash based bookkeeping, they do not pay taxes until funds are received. For instance, if you get paid in February for an invoice sent in November, you do not need to pay taxes for this transaction until the next fiscal year. It can help startups, freelancers, and agencies maintain positive cash flow by freeing up more funds before taxes need to be paid.
The Cases For Using Accrual Accounting
Accrual billing accounting is a more complex prediction-based billing strategy. Find out what makes it a potentially better option for growing enterprises, agencies, and freelancers.
Best Profit Analysis
Accrual payments generate an accurate future-oriented picture about the gains of your business. It helps you assess the incoming and outgoing money at every point of time regardless of the date invoices were paid. Hence, you can assess true profits of the company over longer periods of time.
Insightful Information
By choosing the accrual method of accounting, you can create perceptive financial reports. Admins can use stats and analytics to upgrade a business through different measures like increasing inventory or staffing resources. Keeping in touch with your business goals and related expenses is one of the pros of this system.
Tax And Compliance
By following the Generally Acceptable Accounting Principles (GAAP) put forward by the Financial Accounting Standards Board (FASB), accrual income is demanded by many banks and lenders when calculating a business’s revenue. This is the right billing system for companies that generate more than $25 million annually. Moreover, when your business expands in the future, you do not have to start from scratch.
How Do I Choose The Best Method?
When you are trying to choose the best type of billing system for your business, there are no shortcuts.
While accrual accounting assesses the economic status of your business, it fails to offer a real-time idea of cash flow. Conversely, cash basis accounting is convenient and ideal for staggering tax liabilities, but does not provide detailed analytics like the accrual format. Still, by using the latter, you can mitigate financial problems early on.
In short, for small businesses without vast inventories, cash accounting works well. For a moderately-sized enterprise, the accrual method guarantees the most comprehensive outlook.
Making The Switch
It is true that switching to accrual accounting increases the efficiency of the billing system. However, it impacts businesses differently. To make the switch, fill and submit any incomplete IRS paperwork on time.
Once handled, follow the steps on your own or hire a certified public accountant to manage the process for you.
- Add accrued bills
- Reduce cash invoices
- Include prepaid expenditure
- Reduce the receipt amounts
- Reduce prepayments from clients
After making the change to the accrual method, it is important to maintain consistency. Do not oscillate between accrual and cash based methods.
To smooth any transition, make the switch with the help of invoicing platforms such as QuickBooks. You can change the accounting method under the advanced account settings tab within a few minutes.
Summing Up
The cash basis method accounts for payments as you receive or pay them. This is in contrast to the accrual method where payables and receivables are factored into the accounts whenever they are requested.
The first option is great for freelancers and small businesses, while the latter works best for growing enterprises. Going for a system that can accommodate both methods could unlock the best of both worlds as your business grows, making switching easier as well if needed.
