Nearly all the individuals or entities are subjected to one or the other form of taxation. Internal Revenue Service (IRS) allows these taxpayers to choose between different accounting methods. Even though there are just these two methods – cash-basis accounting and accrual accounting, small businesses managing books should be very particular when choosing between these options.
Maintaining financial records or preparing financial reports are what we find encompassed under accounting process. Different methods are defined as per the legalities of businesses, the sales volume, and the inventory status.
To report income and expenses, every business taxpayer should use either of the accounting methods. In this blog post, we will learn and compare both the accounting methods in detail to see which suits better for small business organizations.
Breaking Down Cash-Basis Method
An alternative to complex accrual accounting method, cash- basis in simple words is an accounting method, where income is recorded when cash is received and expenses are recorded when cash is paid.
The transactions for revenue and expenses are accounted for real-time cash flow. Under cash-basis accounting method, a promissory note, customer invoice, or an account receivable is never recorded.
i. Easy to use:
You don’t need the assistance of a professional accountant because it’s a pretty straightforward process. The revenue is recognized only when a payment is received and the expenses are recognized only when they are actually paid.
ii. Easy to track cash flow:
You will have a clear picture of the financial activities, so there will no consequence that you will run out of cash.
iii. Lower Tax Bills (some scenarios):
Not every time, but in certain circumstances, you will be paying less tax on the net profit earnings. That is in the event when there is some delay in the payment made to you and since the sales cannot be accounted with reference to the same, there will be a reduction in tax bills to be paid.
i. No Match – Revenue & Expenses:
This accounting method can actually mislead businesses. The actual revenue earned in a month and the total expenses vetted out until the actual sale will not be clear until you deeply analyze the numbers.
Let’s say you bought $10,000 product in the month of May planning to sell it to your customers. For some reasons you start selling only after June and manage to make $11,000.
Even though the numbers say you made a profit, a month gap show there were less/no sales for some time. The expense that you had to fill in doesn’t account and the profit you made is actually the net profit of two months.
ii. Inaccuracy due to Single Entry System:
You may find it easier to record the income and expenses without having to deal with the complex accounting equations, but with no fixed rules or principles to follow up the financial transactions/the record may lack accuracy. The system will not reflect true profit and loss, which actually defines your financial position.
iii. Not Acceptable for Tax Purpose:
Since the method is defined as an incomplete system, the tax office may not accept the account that is recorded.
Breaking Down Accrual Method
The word ‘Accrual’ defines the process where the revenue/expense is recorded in the absence of actual cash transaction.
As and then when the income and expense is incurred, it is recorded irrespective whether the cash actually changed hands.
i. Better Cash Flow Analysis:
The same point was made even under the former accounting method. But what makes this method better is you are not waiting for the actual physical payment and while doing that you can actually make smarter decisions for the future.
ii. The Match between Income & Expense:
Irrespective whether the cash is exchanged or not; the income and expenses are recorded then and there. I’ll give you a perfect example to make you clear about this concept. Consider a sale on credit.
The sale here is recorded and instead of cash, an invoice is generated. Also, there will be no cash transactions or issuing of checks, but the workflow will be quite similar.
iii. Compliance with GAAP:
Every taxpaying businessman should follow standard accounting principles to stay more compatible for external investments.
And with compliance to GAAP, you can accurately assess the income and debts.
i. Difficult to Implement:
Your business income has increased and now you need to prepare financial statements as per the accrual standards, but it is not easy.
Since the accrual accounting method is compliant with GAAP, you will need a professional accountant to make you understand the rules and regulations.
ii. More Accounts:
To efficiently keep track of a large number of invoices, you must use a good number of accounts.
For example, an account to keep track of money that you have to pay for your vendors and suppliers. And an account to keep track of customer bills and these accounts should be set up in a financial organizational tool called chart of accounts (COA).
This financial tool gives you the complete list of every account, the type of asset, revenue, expense, equity, and liability.
iii. Early Tax Payments:
Again take the example of a sale credit. The product is delivered, a sale has been registered, but there is no actual cash flow in real-time, still, you will have to pay taxes even before you get paid as the sale is recorded.
When should Businesses Use Accrual Accounting
So far we discussed different accounting methods. For small businesses, they would find it more convenient to use cash-basis method. But under certain circumstances they need to switch the accounting method, so let’s analyze the scenarios.
i. When the annual sales of the business exceed $5 million.
ii. If the business is carrying an inventory of merchandise and the gross receipts exceed $1 million dollars.
iii. If you are planning to take a business loan, then switching to accrual accounting method is necessary.