As a business finance consultant, I ask new clients what they’re running their books on, accrual basis or cash basis. And often I hear cash basis because that’s what their accountant uses for their tax return. But for running a company, the “accrual basis” is preferred over cash basis. The good news is that you can run your business on accrual basis and file your taxes on cash basis. Let me explain how to use these two accounting methods.
On accrual basis, transactions are recorded when they occur rather than when they hit your bank account. Strict attention to timing ensures that transactions occurring in a month are recorded in that month. It’s called accrual basis because you record revenue when it’s earned (i.e., “accrues” to your benefit), not when it’s collected. You record expenses when they’re incurred, not paid. This matching of revenues and expenses within a month is central to accounting and to having reliable financial statements.
In accrual method, you record revenues when you’ve satisfied your contractual obligations to your customer (i.e., when you ship the goods or do the work). You record expenses on the date your vendors deliver their goods or services to you. Because you’re recording revenues and expenses ahead of when the cash is received or paid, accrual basis books have accounts receivable and accounts payable while cash basis books do not.
In accounting, the words “record”, “recognize” and “post” are synonymous. They mean entry into the books. For example, if you deliver goods on the 30th day of the month you’ll record that revenue on the 30th day of that month, rather than the date your billing department prepares the invoice some days later. If you’re a service company, like a law firm, you should date your invoice and record the revenue in the month you performed the work.
Payroll expense is a typical accrual at month end because hours worked in the days leading up to month end are usually paid in the first paycheck of the new month. So, the payroll expense for hours worked through month-end must be calculated and recorded (i.e., accrued) on the last day of that month. In this way, the prior month books have a full month of labor cost to match its full month of revenues.
The results would be different on the “cash basis” in which transactions are recorded when they hit your bank account. Revenue received less expenses paid in a month yields a different net income than does the accrual basis. When you receive revenue depends on the credit terms you extend to customers and when you pay expenses depends on credit terms your vendors give you. The timing of those receipts and disbursements bear little relationship to each other which could make your month-to-month net income appear like a cardiogram, positive one month and negative another. The accrual basis yields more consistent monthly net income than does cash basis and because it matches revenues and expenses better than cash basis, it’s the best basis on which to base management decisions. Month-to-month financial comparisons will prove more meaningful and understandable.
Generally, accrual basis is demanded by investors, lenders, and vendors because they want to see your revenue and expenses when they occur, not when the cash is received or paid. Cash basis is mostly used by tax accountants in preparing tax returns. Why? Because when a company is growing, cash basis can result in lower taxable income and a deferral of tax from one year to another. How? Because revenues that are in receivables at year end on accrual basis are not recognized on cash basis until the next year when they’re received. And expenses in accounts payable at year end on accrual basis are not recognized on cash basis until the next year when they’re paid. In simple terms, the excess of receivables over payables is the amount of income that gets deferred from one year to the next. The taxes on that income get deferred to the next year, giving you the time value of such money until the following year when on cash basis you must pay it.
Here’s the nice thing. Most accounting software such as QuickBooks can run your financial statements both ways, on accrual basis and cash basis without double work by your bookkeeper. Your bookkeeper should maintain the books on accrual basis and 1) record sales invoices when you ship the goods or deliver your service, 2) record expenses on the date they’re incurred, 3) record cash receipts when they’re received and 4) record cash disbursements when payments are made. With all these transactions so recorded, the software can calculate your accrual basis financial statements (which will include accounts receivable and accounts payable) and your cash basis financial statements (which will not have accounts receivable and accounts payable).
So, you can put your best foot forward by giving accrual basis financials to investors and lenders, while still filing your taxes on cash basis and deferring some taxes for a year. Pretty cool.
Here’s an illustration of the differences in the financial statements of accrual versus cash basis books using the same assumed transactions.
Note how cash balances are always the same on both methods. But accounts receivable and accounts payable only exist on accrual basis. Finally, note the difference in timing of sales and cost of goods sold. It’s recorded in December on accrual basis when the goods are shipped, yet it’s recorded in January on the cash basis when the receivable is collected and payable is paid. So, 2018 net income is higher on accrual basis than cash basis. And it’s the opposite in 2019. Using cash basis for tax purposes just shifted the $50 net income to the next year, which deferred the tax on such income for a year.
Now that you understand both methods and how to use each, I hope you’ll use accrual basis for your day-to-day management of your business. If you like this blog, please share it and like it here on this site. And please comment too.
This is Robert Band, your business finance expert. Would you like the relief of better financial management and results? Then let me put the right pieces in place for you. Remember, one tip could be worth millions and profits today become fortunes tomorrow. So, don’t let them fall through the cracks.
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Robert Band
Business Finance Expert
Email: reb@robertband.com
Phone: (305) 467-5909