Let’s all face it – accounting can be difficult to understand, and it’s sometimes as if accountants speak their own language. What exactly does it mean to “write something off”? Who else besides an accountant uses the term accrual? And why would there be two separate types: cash and accrual accounting?
These are all fair questions, especially the last point. Since cash is king, why would we need to account for financial transactions with a different method? Cash represents reality, while accruals are confusing and could be a trick that accountants use to “cook the books.”
As a small business owner you may be thinking: Why do I need to worry about accruals? My number one concern is managing my cash, so shouldn’t I account on a cash basis?
Having cash as your top priority is exactly why you should be employing accrual basis accounting! By using accrual accounting your associated revenues and expenses are recognized in the same period, leading to an accurate depiction of gross margin. Known as the matching principle, this in turn leads to accurate cash flow forecasting, so that you can better plan accordingly for future receipts or expenditures of cash.
What is Accrual Basis Accounting?
Before deciding on which of these two methods of accounting is best for you, let’s first understand the differences between cash and accrual accounting. Cash basis accounting records transactions on the day when cash is actually received or paid, whereas accrual basis accounting records revenues and expenses when they are earned, regardless of when cash changes hands.
Consider the following example:
In January, ACME orders and pays for an anvil to be re-sold, which is received during the month. Then in February ABC sells that anvil to Wile E. Coyote. Wile E. Coyote pays for the anvil in February, but does not receive the anvil until March.
Notice how the cash basis shows a massive loss in January, massive profit in February. Does that mean the company was mismanaged in January? No, it just means the accounting is bad. On an accrual basis, we see the costs paired with the revenue in March, allowing ACME management to understand they made a profit off Wile E. Coyote.
This simple example only shows a single transaction, but in real life ACME is selling hundreds of anvils, rockets, roller skates, and road runner traps every month. Without a good accrual accounting system, their financials would be unusable.
When Should a Business Owner Use Cash Basis or Accrual Basis?
Not sure which accounting method you should use? Here’s some situations where accrual accounting is best:
Understanding Your Gross Margins-
As seen in the ACME example, cash basis accounting tends to cause monthly fluctuations of gross profit calculation. This is the number one reason small business owners can’t plan growth.
Accurately Calculating Working Capital-
Inventory, Accounts Receivable, Accounts Payable, Unearned Revenue, and other balance sheet accounts are not included in cash basis accounting, which, counterintuitively, makes it more difficult to forecast cash. In fact, accounting rules generally exclude the use of cash basis accounting for companies that have inventory and corresponding COGS (there are very limited exceptions to this).
GAAP Compliance Requirements-
Accrual accounting is considered best practice within Generally Accepted Accounting Principles (GAAP) as well as through the standards of the Financial Accounting Standards Board (FASB). This may not be a top concern right now – especially if your company is not required to undergo an annual audit – but if you are planning for an exit from your company in future years you will need to eventually convert your books to accrual to comply with GAAP. The process of converting from cash to accrual will be more costly and time-consuming the longer you wait.
Analyzing Your Profitability-
The accrual method will provide a more accurate picture of your true net income, though your income taxes will likely be calculated on a cash basis. That’s why CPAs usually perform small business accounting using the cash basis method. What many entrepreneurs don’t realize is your CPA can quickly convert your financials from accrual basis to cash basis for taxes, so don’t let the tax format drive your business financial reporting.
Sales Tax Compliance-
Sales tax companies normally require businesses to use accrual basis accounting to use its software in calculating accurate sales taxes. With sales tax calculation and accounting becoming increasingly complex as rules vary on a state and local level and taxation bodies becoming more vigilant in their enforcement, many businesses are turning towards software solutions to assist with the sales tax profit.
Cash Basis is Cheaper-
The only downside to accrual basis is its cost to maintain. Small businesses often don’t want to pay monthly accounting fees for accrual basis bookkeeping. However, cash basis is often more expensive in the long run due to delayed cleanup expense or trouble during due diligence when trying to sell the business.
Should I Use Accrual Basis Accounting?
CFOshare recommends accrual basis accounting for if your small business is:
- Expecting to exceed $1M in the next 12 months
- Planning to raise angel or venture capital equity
- Large enough to have 5+ employees
Still not sure whether cash or accrual basis is right for you? Book a call with one of our CFO’s to discuss your specific situation, we are always happy to meet new entrepreneurs!