Starting up a business involves major operational decisions. One has to do with choosing how to speak the language of business, i.e. your accounting method. You may be asking should I use cash or accrual accounting? Both have their advantages and disadvantages.
In this article we will go over:
- The cash and accrual methods
- Examples of each accounting method
- The pros and cons of cash vs accrual accounting
- The difference between accrual vs deferral journal entries
- How each accounting method affects taxes and inventory
Cash vs Accrual Accounting: What is the Difference?
There are two accounting methods to follow in bookkeeping. Understanding them is no piece of cake. We use a bakery business, to provide a real life example of cash and accrual accounting:
What is Cash Basis Accounting?
When you record cash as it comes into and when it leaves your business. Journal entries are only made when money literally changes hands.
Example of Cash Accounting
It is July, and a customer orders a wedding cake from your bakery. The cake will be picked up at the beginning of September. The customer puts 50% down as a deposit, you record this as revenue in July. You buy some supplies for the cake at the end of August, and you record this as an expense for August. When the customer picks up the cake, the remaining revenue is recorded in September.
Pros and Cons of Cash Basis Accounting:
Simple to understand
Better when mainly dealing in cash transactions, and/or not carrying much inventory
Many countries recognize this method of recording below a specific revenue threshold
Easy to see actual cash flow
Less tax when paying suppliers up front.
There is a timing difference in records, causing fluctuations of profit and loss.
Not advisable for a large volume of transactions.
Not a clear view of the books
Not compliant under GAAP or IFRS
Not investor friendly
What is Accrual Basis Accounting?
Transactions are booked as they are earned or incurred. The accrual method follows the Matching Principle. Meaning all costs and revenue need to be recorded in the same time period. So accrued revenue may not have come in yet, and accrued expenses may not have been paid for, but with the accrual method transactions are recorded together.
Example of Accrual Accounting
It is July, and a customer orders a wedding cake from your bakery. The cake will be picked up at the beginning of September. The customer puts 50% down as a deposit. In July, you purchase some inventory for the cake but you will not bake it until September.
At this point in July, there are no transactions that affect income or expenses. The deposit sits on the balance sheet as a customer prepayment. It is not revenue yet because the cake is not ready. The raw materials, expensed to make the cake, will be on the balance sheet as well. It is not reconciled because the cake is not ready yet. The balance sheet is a temporary placeholder for accrued journal entries.
Come September, the customer picks up the cake and pays the rest of the order. Now the 50% deposit and the remaining cash received, is recognized as revenue. You will also recognize all the ingredients you used for the cake. They are adjusted as an expense in September so revenue and expenses line up in the same period.
Accrual vs Deferral Journal Entries
In accrual accounting you will organize transactions as accrual or deferral journal entries. What is the difference between accruals vs deferrals? The main difference between the two, is a when to record them in the books. Accruals are reported immediately, paid later. Deferrals are paid immediately, reported later. Below are different types of accrual accounting journal entries to be familiar with. We use the above cake scenario to provide examples of each:
Accrued Expenses aka Accrued Liability: An example would be bi weekly payroll for the bakery employees. Pay periods that cross over two months, report pay in the first month. The expense would sit on the balance sheet as a liability. In the next month, a check would be paid out to the employee. The amount then is debited on the income statement.
Accrued Revenue aka Accounts Receivable: When the bakery provides cakes for a catering service. This is revenue that is earned but payment is received in a later accounting period.
Prepaid Expense aka Deferred Expense: Occurs when a company pays an expense up front and reports it in a later period. These expenses apply to larger items that will be used over time. An example could be the bakery’s catering delivery van.
Deferred Revenue aka Unearned Revenue: Prepayments for a service to be delivered or performed in the future. The 50% deposits collected on preorders, are considered unearned revenue. Since no transaction has been recorded this prepayment is a liability on the balance sheet.
Depreciation: When a company purchases a piece of equipment. They will spread the cost out over its expected lifetime. Versus expensing it right away. Any heavy equipment for the bakery could be depreciated.
Amortization: A planned repayment of intangible equipment. Items like patents for special equipment. Businesses need to pay for the rights, if they don’t own the patent. Perhaps the bakery relies on a unique oven that produces a better bake. This oven would be amortized over time.
Pros and Cons of Accrual Accounting:
Better management of large inventories
Easier for GAAP and IFRS
Gives an accurate view of AR/AP
Minimize cash leakage from errors
Easier to predict income for quarterly taxes
Less taxes when you accept prepayments and deal with long term contracts.
Cash flow is not immediately visible.
Have to make estimations about transactions
More complicated to understand
Why is Accrual Accounting Preferred Over Cash Accounting?
We use accounting to gain business insights. With accrual accounting you can easily do that! You get a better idea of fluctuations of revenue, to plan and allocate money for costs. Even better, it is a more precise method of recording. By following the matching principle and double entry, you reduce errors. As a whole, it is better for seeking investment and adjusting to GAAP rules.
Taxes for Cash vs Accrual Accounting
New companies determine their method of accounting with their first tax return–without IRS approval. At a certain revenue threshold you will need to change your method of accounting. Any change requires filing Form 3115. The new accounting method has to be approved by the IRS.
You have to stick with a system. The IRS regulates who can file under each method. If businesses were able to switch liberally, there is the potential to push money around to pay less in taxes. Consistent accounting procedures are key to keeping you far away from the IRS.
Here are important notes about each method for taxes:
Taxes with Cash Basis Accounting
Who can use the cash method of accounting? Great question! A good way to find out if you can file using the cash basis method is the gross receipts test.
- Generally, these companies CANNOT use cash accounting:
- Corporation (not an S corporation) with annual gross receipts exceeding $25 million
- A partnership with a corporation as a partner (not an S corporation) and with annual gross receipts exceeding $25 million
- Tax shelters
- Businesses selling products or services on credit, or vice versa making purchases on credit
- Businesses with inventory. (Some exceptions apply see inventory section)
- Cannot report receivables as income or deduct promissory notes as payments.
- When filing, minimize taxes by taking on expenses in the year you want them to be counted in.
- Auditors will not certify a cash-basis income statement. It will have to be converted to accrual.
Taxes with Modified Cash Basis Accounting
A practice that uses elements of accrual accounting with cash basis. Accrual is used for line items like inventory, depreciation, and amortization. While the majority of items are recorded on a cash basis.
- When filing, if the item clearly reflects income it is deemed permissible.
- This special filing method must be used consistently year to year.
- Not accepted under GAAP and IFRS
Taxes with Accrual Basis
- Businesses that must use accrual accounting:
- C corporation
- Annual gross receipts exceeding $25 million
- The IRS allows you to write off debts owed by clients, that is included as income.
- When filing, minimize taxes at the end of the year by sending bills out in the next year. Also you don’t have to pay a bill in that year. However, you cannot deduct expenses in advance.
Inventory: Cash and Accrual Accounting
When it comes to which accounting method to use, inventory is a deciding factor. There are regulations on how inventory can be recorded for tax purposes. Take these notes into consideration with each method:
Cash Accounting Method: Inventory is tracked when it is purchased. It is preferred with a slow inventory turnaround and single fulfillment center. When filing inventory is reported as “non-incidental materials and supplies.” Deduct when the item is sold, or when it is purchased from a vendor, whichever is later.
Accrual Accounting Method: Inventory is tracked when the order is incurred. This method is advised with multiple fulfillment centers, and with high inventory turnover–more than 3 times per year. Inventory is recognized as cost of goods when it is shipped to the end user. You can deduct inventory once it is shipped to the end user.
The Best Accounting Method for My Business
Based on the above article, you should have a good understanding of the best method of accounting for your business. Good rule of thumb: If you take future payments, for future sales, you definitely want to use the accrual method; If you make sales but receive cash later, the cash method is the best. We always recommend the accrual method since it provides the clearest picture.