Key Takeaways
- Easeify only works with service businesses and non-profits on the cash basis
- The difference between cash and accrual basis lies in the timing of when transactions are recorded on the books
- With the cash basis, revenue and expenses are only recorded once money has been received or spent according to the bank
- With the accrual basis, revenue and expenses are recorded once earned or incurred even though money has not been exchanged yet
What is the difference between cash and accrual basis?
Cash and accrual basis are methods of accounting differentiated by the timing of when revenue and expenses are recorded on the books.
Under the cash basis, revenue and expenses are recorded as soon as money is exchanged. The books are recorded matching the bank in regard to when income is received and deposited, and when expenses are paid and the funds leave the bank.
Accrual basis, on the other hand, records revenue when earned and expenses when incurred, but not exactly when the money changes hands. The accrual basis follows GAAP (Generally Accepted Accounting Principles).
Cash Basis Accounting
If the cash basis of accounting is used, revenue will only be recorded when money has been received. Expenses will only be recorded when money is paid out. There are no accounts receivable or accounts payable being recorded in your financial statements with this method.
Income will be recorded on your books once the funds have hit your bank account and are available for business use. Expenses will be recorded once they have hit your bank account and are no longer funds you have access to use.
Accrual Basis Accounting
With the accrual basis, revenue is recorded when it is earned, but you may not have actually received the money yet. The income is recorded and goes on the books as soon as a service is completed or a product delivered to the customer (accounts receivable – money that is owed to you).
Likewise, expenses go on the books before they are paid (for example, once a vendor’s invoice is received). Also known as accounts payable, money that you need to pay. These transactions are recorded in anticipation of money changing hands in the future.
Example of the Cash Basis
A cleaning service company provides services to a client December 13th, 2023. The client agrees to pay $300 for the service, and the work is completed. However, the client does not actually pay for the service until January 2nd 2024. With the cash basis, the $300 of revenue will not be recorded on January 2nd 2024 since that is when the money is deposited into the company's bank account.
Suppose this company also pays $2,000 for office rent on the first of every month. The January 1, 2024 rent expense will be recorded on January 1, 2024 when it is paid, as expenses are recorded once paid.
Example of the Accrual Basis
Using the same examples from above, the $300 of revenue would be recorded on December 13th, 2023 under accrual accounting, vs. when the funds were actually received, in January. This is because the money was earned in December, that is when the services were performed and completed, even though the money was not received until January 2024.
The January 1, 2024 rent expense of $2,000 would be recorded in December 2023 because that is when the expense was incurred, the rent was for December, not January, even though it was paid in January.
Advantages and Disadvantages of the Cash Basis
The cash basis is very common among sole proprietorships and small businesses due to its simplicity. Determining whether a transaction has occurred is straightforward as it depends entirely on whether money came into or out of the bank account. There is no need to track receivables and payables, although you can still have invoices and bills, the financial statements will only record invoices that have been paid and bills that have been paid.
It is easy to tell how much money is available to the business by looking at the bank balance at any given time. This characteristic is useful for accurate cash flow management and managing day-to-day finances.
There may also be a tax benefit to using the cash basis. By carefully timing transactions, it is sometimes possible to delay revenue and push expenses forward to lower taxable income.
One of the downsides to using the cash basis is that it does not always accurately portray financial performance. Since payables are not recorded, business owners may believe they have more money to spend than they actually do, especially if a large bill is in the future. This can have an impact on decision making and business growth.
Additionally, some large corporations are not allowed to use the cash basis. For example, corporations (other than S Corporations)with average annual gross receipts for the previous three tax years of over $29million are required by the IRS to use the accrual method.
Advantages and Disadvantages of the Accrual Basis
The accrual basis offers a more precise picture of a business’s financial health if your business has many accounts receivables and payables. It takes receivables and payables into consideration so that revenue is matched with expenses. This is helpful for keeping an eye on true profitability for each period.
However, the accrual basis has additional complexities as it is governed by extensive rules and regulations.
At Easeify, we do not work with accrual basis clients.
Should I Use Cash or Accrual Basis For My Books?
Choosing the right accounting method is an important decision for any business, and it depends on several factors.
The cash basis is generally best for smaller businesses that do not maintain inventory for their operations, such as service businesses and non-profits.
Large businesses and inventory-based businesses may decide, or be required by the IRS, to use the accrual basis. Businesses that anticipate to go public in the future may also choose to start with the accrual basis to avoid undergoing a potentially challenging switch later on.
As long as they qualify, businesses can get approval from the IRS for a change in accounting method by filing Form 3115. Please note that it is easier and better to change from cash basis to accrual basis, versus the other way around.
Sources:
BDO - $29 million cash basis threshold for 2023
IRS - Businesses required to use accrual basis
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