To account for variations in entity type, reporting requirements, tax requirements, and other considerations, two methods of accounting were created – Cash basis and Accrual basis. The main difference between the two has to do with the timing and ways that income and expenses are recorded in relation to actual cash inflows and outflows.
What is Cash Basis?
Cash basis accounting closely follows actual cash movement, since the recording of transactions is tied directly to the bank account. That means that income and expenses are recorded in the same period as the cash moves in and out of the bank account, making it easy to track and attribute income and expenses monthly. However, because the method is tied to the bank account, it is difficult to track Liabilities and Accounts Receivables (Money owed and income earned). If work has been performed, either by you for a client, or by a vendor for you, the impending income and expenses will not be reflected on financial statements until money changes hands.
Another struggle with cash basis accounting is that this method does not match expenses to the period in which revenue is earned, creating a disconnect on a per-job basis. It becomes more difficult to track whether a job spanning multiple reporting periods is truly profitable or not.
What is Accrual Basis?
The Accrual method aims to ensure that income and expenses are recorded on financial statements in the period in which they are incurred, instead of when the cash changes hands. With this method, Accounts Receivable and Accounts payable and other liabilities are more visible on the financial statements, because transactions are recorded now, while the actual cash transactions will happen at a future time.
The accrual basis allows for a clearer picture of full earnings and expenses, and can track unpaid income. The ability to record income and expenses when they are incurred and earned allows per-job costs analysis to be performed. The accrual method monitors the actual position of the company, separately from the bank statement, and is more accurate.
However, the accrual method tends to require more management on the owner/accountant’s part, and there are additional closing and adjusting entries to be entered each month.
Which Accounting Method should I Use?
For most small operations, small LLCs and S-corps, using the cash basis method is usually sufficient. If the owner is involved in more complicated activities, tracking inventory, job costing, extending credit, etc, they may consider converting to accrual basis. C-corporations are required to use accrual accounting, as it allows for more detailed financial reports, whereas cash basis only provides simple reports. However, it is possible to convert from one method to another with a few adjusting entries, though the IRS does not allow too much flip flopping.
As an owner, deciding which accounting method is better for your business can have an important impact on your financial reports. Be sure to ask any questions you have related to this to your accountant, as they can provide benefits and issues specifically related to your business.