Accrual verses Cash Accounting can be one of the more difficult accounting concepts for non-financial people to understand. For the small business owner, every transaction is on a cash basis. They understand revenues and expenses, but what is all this accrual stuff?
The foundation of accrual accounting the accurate recording of revenues earned and expenses incurred for the specific period. For example, paying the annual business insurance premium depletes cash in the month paid. This also applies to the upfront insurance premium payment, and subsequent month billings. This insurance is going to cover the business for a 12-month period, but the cash outlay occurs in one month or over a nine-month period.
Accrual accounting uses a prepaid insurance account and journal entries to capture the payment and record the monthly portion. This prepaid account is a current asset, used to record the payments. The accountant then takes the annual amount of the premium and divides it by 12. Each month, a journal entry is made to record the current month portion of the business insurance premium as an expense, and reduce the prepaid business insurance account.
Accrual Accounting records revenue as it is earned, and expenses and purchases when they are incurred. This is done using the Accounts Receivable and the Accounts Payable accounts. When a customer is invoiced, this is revenue earned. The revenue flows into the monthly reporting to show how much revenue was earned to record profit for the month. Accrual Accounting does not consider the customer payment as when the revenue was earned.
When a bill is received for the business, and when payroll is generated, the associated expenses and liabilities are recorded on an accrual basis. This means that, regardless of when the expense is paid, the business expense is considered spent in the month it is recorded. The Accounts Payable Account is a current liability, as are the payroll taxes. The payroll taxes, both the employer and the employee portion, may be due weekly, monthly or quarterly. In accrual accounting, these are considered a business expense in the month they were incurred, and are classified as accrued expenses, or current liabilities.
Cash basis accounting ignores the concept of Prepaid and Accrued expense, as well as Accounts Receivable and Accounts Payable. This method recognized cash when it is received and cash when it is spent. It does not represent a true picture of the business net worth.
Cash Basis may seem simpler to use for the business owner. But using a cash basis can have results that make it more difficult to monitor the business profitability on a monthly basis. While your sales may be booming, your customers may be delinquent in paying. Using the cash method, you may see revenues well under the actual monthly sales. Or the net profit is distorted because there were larger purchases in the given month. Accrual accounting takes these events into account when creating the monthly Profit and Loss statement.
Choosing an accounting method is necessary when preparing the taxes for the entity. The method of accounting must be chosen and stated on the first tax return submitting for the business. When choosing, the method chosen should most closely represent income and expense, and the IRS suggests that the method chosen be used for the business record keeping.
Cash and Accrual are two of the available methods for record keeping and tax reporting. While the IRS states the methods in Publication 538 on page 8, cash and accrual are the most popular choices. There are some factors that affect the type of method a business chooses.
If a business maintains an inventory, the sales and purchases must be reported on the accrual basis.
If a business is a corporation, not a Sub Chapter S Corporation, and has gross receipts in excess of $5 million, the cash method cannot be used.
A partnership where one of the partners is a corporation, but not an S-Corporation, and the partnership exceeds $5 million in gross receipts, the cash method cannot be used.
Under the accrual method, the business reports revenues in the year earned, and expenses are deductible or capitalized in the year incurred. Under the cash method, revenues are recorded for the period when the cash payment is received in the bank and available for business use. Expenses for the period are reported when these are actually paid.
Understanding the differences in the Accrual method and Cash method of accounting is a helpful step when setting up record keeping for the business. While the Cash method seems the easiest, the benefits of accrual reporting include the ability to deduct business expenses that are recorded but not yet paid on the tax return.
In order to have a more accurate picture of your business performance, the accrual method is a better choice. In order to keep quick and easy records of transactions, the cash method may be the choice. Regardless of the method chosen for the business, there are advantages to each.