Every company needs to keep records of the money flowing in and out of the business. There are two distinct accounting methods for recording business activity, and each has its advantages and disadvantages. It is important for business owners to understand the difference in the two methods and choose the right one for their business.
Cash Basis Accounting
Cash basis is a type of accounting for business activity that involves recording revenue when it comes into the business, and expenses when they are actually paid out. This type of accounting is typically used for smaller, less complex businesses. The cash method can be a less accurate way of recording activity in the short term, since sales could be agreed to or expenses incurred, even though no money has been received or paid out.
Accrual Basis Accounting
Accrual accounting is used for larger or more complex businesses. Certain companies must use accrual basis accounting, if the company has annual sales of more than $5 million, or the business sells an inventory of items to the general public and has gross sales of over $1 million annually. Accrual accounting requires revenue to be recorded when it is earned, even if a sale is made on account and the actual money will not be received until some future time. Accrual accounting also requires expenses to be recorded as soon as they are incurred, even if they have not yet been paid. Accrual basis accounting is more favorable for tax purposes.
Choosing the cash or accrual method can affect how much taxes are paid each year. When using the cash method, any expenses incurred but not paid until the following year will not be eligible for a deduction on the company’s taxes. Depending on the type of business and expenses incurred, the difference could be substantial. Additionally, the accrual method lets businesses plan to incur expenses in the current year, lowering taxes, while holding off on some sales until the next year to keep revenue lower. The change will catch up in the next year, but the flexibility can help businesses plan their finances more effectively.
Cash basis may give business owners an unrealistic view of how the business is doing, since they do not know about any transactions that are pending, but not recorded. This would be important if the company needed to know if it would have funds available in the near future to pay a large tax bill. Conversely, the accrual method can show more realistically how income and expenses fluctuate for a business, but the actual cash reserves are not as easy to see. Accrual accounting might show a large volume of sales, although no cash has yet been received. This could also cause difficulties when planning for any large tax payments.