Cash versus Accrual Accounting. The Difference Could Kill Your Business.
I sometimes receive questions on why Total Office Manager does not allow for cash basis financial reports (like we do for sales tax reports). Cash basis accounting is not GAAP compliant and has NO PLACE in business management. A cash basis is how a person manages their personal checking account, not a business enterprise. In fact, cash basis financial management is dangerous and places your company in jeopardy. Let’s look at the differences.
Accrual-Basis Accounting Method
Small business owners should abide by the generally accepted accounting principles (GAAP — more on that below). One of the most critical components of GAAP is the accrual-basis accounting method, which states that companies should recognize revenues and expenses at the time of a sale. This is different from the cash basis method, which says that you should realize sales when you receive payment.
The accrual basis accounting method is efficient and provides you with a better indicator of your financial position, as it shows the present value of sales revenue. It also requires the double-entry method of accounting. When you enter an accrued transaction, you enter a matching transaction in a different account.
So, let’s say that you sell $10,000 in raw materials and that the buyer agrees to pay $2,500 for four months. These sales take place in November. Under the cash basis method, you would need to create a journal entry each time you receive payment, which means your financial reporting will take place throughout two accounting periods — the end of year one and the beginning of year two. Under the accrual bookkeeping system, you’d log the sales in your receivables account and debit inventory.
Cash-basis accounting is a straightforward accounting method. Under the cash-basis accounting system, you record payments when they’re received or processed. Accounts receivable do not come into play under the cash-basis system.
For instance, let’s say you perform work for a client on March 1 and submit an invoice due in 45 days. The client pays the balance in full on April 15. Under cash-basis accounting, you’ll record the income in April since this is when you received the cash in hand.
If you don’t maintain inventory, you may find cash-basis accounting more useful than accrual-basis accounting. It could also be particularly helpful for service-based businesses. However, it does not meet GAAP standards, which can be problematic if your business grows. Certified public accountants may recommend that you don’t use cash-basis accounting for this reason.