To stay on top of the accounting side of your business, and to keep bookkeeping processes clean, it is essential to consider which financial reporting methods would best suit the needs of your business.
Understanding cash vs accrual accounting and how it can impact cash flow and taxation within a business can help you select the best practice based on your business needs and structure.
What Is the Difference Between Cash and Accrual Accounting?
When a business uses the cash accounting method, the owner reports income during the receiving year and deducts expenses when paid in that year. The accrual accounting method differs by recognizing and reporting income in the year it was earned, regardless of payments not received, and deducting expenses when incurred.
Importance of Accounting Methods Within a Business
Determining how much taxes you owe to the IRS or having an accurate view of the revenue and expenses of your business is the most significant reason for determining the accounting method your business uses. The cash and accrual methods reflect your business income and deductible expenses for reporting on your federal tax return every year, and it provides you with a holistic view of the financial inputs and outputs of your business within a year. This is an important difference between the accounting methods as cash-based accounting will give you an overview of how much cash you received and the accrual-based method shows you how much business you have done, regardless of whether the money has been received by your business in the year of performing the business or not. Each of these methods has its perks and downfalls.
Which Accounting Method Is Typically Used by Small Businesses or Larger Companies
Small companies and nonprofit organizations that do not sell, produce or purchase products are more likely to select the cash accounting method. If a company makes over $25 million in sales for three consecutive years or has any inventory, the Internal Revenue Service requires using the accrual-based method. You must practice it if you have employees, received a large amount of funding, or plan to raise more funds for a business venture.
Advantages and Disadvantages of Accounting Methods
Although there are advantages for businesses and individuals to using the cash and accrual methods, each method has its disadvantages.
When using the cash-based accounting method, there are three advantages, including:
- The easiest accounting method for reporting revenue and expenses.
- The best useful method for small entities and nonprofit organizations with no employees on the payroll or plans for expansion.
- Possible deferment of taxable income because the money is not actually received for product purchases or services.
Disadvantages of using the cash accounting method include:
- You may not be able to use the cash accounting method if you live in a state that requires businesses to use only the accrual accounting method.
- The cash accounting method is not accepted by GAAP.
- The method does not record accounts payable and accounts receivable.
- The method does not provide an accurate picture of a company’s financial position.
- It may not provide an accurate picture of the cash flow of your business.
By practicing the accrual method, a business can provide a more accurate report on how much money is earned or spent on expenses. This method follows the Generally Accepted Accounting Principles and is a practice for audits following the guidelines. Two disadvantages of using the accrual accounting method are it’s a more complex accounting method than the cash-based, and you may pay taxes on revenue not received from customers or clients.
Effects of Cash and Accrual Accounting Methods on Cash Flow and Taxes of a Business
Cash flow is a statement reporting your company’s inflows of cash earned and the outflows of paid expenses. It would be best if you tracked your cash flow to ensure you have enough available funds to pay for your expenses and purchase assets for the business. The statement shows the net cash generated for a period, which is presented in three activities, operating, investing, and financing. When using the accrual method, revenue and expenses do not affect cash flow because cash is not yet payable. Cash flow sums impact the statement with changes in accounts receivable and payable rather than the accrued expenses and revenue.
Publicly traded companies and businesses must use the accrual method if they have investors or lenders for tax purposes and financial reporting. Whereas the accrual method doesn’t track cash flow, the cash method is easier for tracking cash flow. Accounting software, such as QuickBooks or NetSuite, are solutions for recording and reporting a business revenue and expenses using the accrual or cash accounting method.
The Most Appropriate Accounting Method for Your Business
Consulting with an accounting professional, CPA, or tax specialist is helpful when determining which accounting method would work best for your entity and its business needs. There are many factors to consider when determining the appropriate accounting method to use for your financial reporting.
At Fusion CPA, our CPAs understand how cash vs accrual accounting methods affect financial reporting and tax preparation for your company. We can help you choose the most appropriate accounting methods for your business, and set up your accounting software to record transactions according to this method. This will not only help you gain a more accurate financial understanding of your business but will also help keep financial records accurate for tax filing.
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