One of an accountant’s basic goals is to keep accurate and useful records of financial transactions. Individuals, small firms, large corporations, and even whole countries faced with this task have two major methods from which to choose: the cash basis of accounting and the accrual basis of accounting.
The basic difference between the two methods has to do with the timing of when you record financial transactions. Under the cash basis method, you record income only when payment is received and expenses only when they are paid out. You update your books when money actually changes hands. By contrast, in the accrual basis you record income when it is earned and expenses when they are incurred. If you make a sale, your books reflect that income, even if you have not yet received payment for that sale.
Note that if you actually pay or get paid the amount in full of any transaction at the very same time you agree to that sale or purchase, your ledgers will look the same no matter which accounting method you use. That is, the two accounting methods primarily differ on paper due to the timing of when cash changes hands.
BLet’s look at each method in turn to understand its characteristics, benefits, drawbacks, and effects.
The cash basis is simple and straightforward compared to the accrual basis and is most often used by small businesses that do not require financial statements that comply with GAAP (Generally Accepted Accounting Procedures).
Cash accounting simply records revenue when it is collected and expenses when they are paid. If Harry’s Haberdashery, which uses cash accounting, sold you a fedora on credit in November 1936, and you paid for it in January 1937, Harry would record the revenue in January when the cash actually appeared in his bank account.
This system gives you an accurate picture of cash on hand, which enables smooth cash flow. The cash method’s downside becomes apparent in its lag time in capturing the big-picture financial state of a business. If you follow the cash basis and, say, have significant liabilities you haven’t paid off, or just completed a major project for a client but haven’t yet received payment, be aware that this method could give you a very misleading picture of your business’ financial health.
Accrual basis accounting has been an option in the United States in 1916, and as the economy has become more and more complex, this method has become more and more common. For example, the Tax Reform Act of 1986 prohibits C corporations from using the cash basis. Indeed, most large companies now use the accrual basis, as it is the system best suited to their bookkeeping needs and is often even required by IRS regulations. Even though it is more complicated and expensive to implement than the cash basis, the accrual basis is now the standard accounting method practiced in the US.
Because all financial institutions (banks, investors, etc.) now require financial statements that comply with GAAP, the accrual method is by far the leading method among businesses in the U.S.
In the accrual method, income and expenses are credited or debited to accounts when sale and purchase agreements are made, even though the money may not have changed hands yet. If Betty’s Boutique, which follows accrual accounting, orders a hundred parasols from a distributor in December 2016 but doesn’t pay for them until March 2017, Betty would still record the expense as an accounts payable (a liability) in December, when she placed the order.
The accrual basis is meant to convey an accurate picture of a company’s overall financial strength, a concern which tends to be more useful and important for most businesses than tracking short-term cash flows. One shortcoming of the accrual method is the inability to provide a snapshot of cash flows. Thus, businesses have adopted supplementary reporting methods to track the actual balances in your accounts to avoid cash flow problems.
Accounting bases that combine elements of both cash and accrual methods, though uncommon, do exist. Such methods are variously called modified cash basis and modified accrual basis and come in many different flavors. For example, you could record income when it is earned but expenses when they are paid out. So income is recorded on the accrual basis, while expenses are on the cash basis.
When using the modified cash basis of accounting, check with your accounting team to ensure conformity to GAAP, which spells out the standards for the financial statements of domestic firms in the U.S.
Effects on Income Taxes
The two accounting bases affect businesses most significantly when it comes to paying annual taxes. In our examples from before, Harry, who recorded the fedora sale and revenue in January 1937, would only be taxed for that income on his 1937 tax return. Betty, who recorded her parasol purchase in December 2016 even though she didn’t pay for them until a few months into the next calendar year, could write them off as a deduction for her 2016 taxes.
In the past, many businesses using the cash basis would pay off expenses before the end of a given tax year but wait to bill clients until after the year’s end. This technique would maximize their deductions but put off reporting and paying tax on much of their income. Such manipulations meant to minimize taxable income have led the IRS to discourage cash basis accounting for many types of companies.
Armed with a solid understanding of the tradeoffs involved in navigating these two major branches of accounting, you can better choose the basis that will serve your company best.
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