One question that comes up often is what is: the difference between the cash basis of accounting and the accrual basis of accounting.
Essentially, there are two main ways to maintain your accounting records and report your earnings: the cash basis of accounting and the accrual basis of accounting. There are other less used ways, but cash and accrual are the two most widely used methods and the two which we will talk about here. Our discussion will focus on the difference in the reported earnings of a company. It should be noted that there are balance sheet differences as well which are outside the scope of this limited explanation.
Simply stated, the cash basis of accounting reports as your net income the receipts actually collected less the expenses actually paid during the period that is being presented for your company. Under the accrual method of accounting, the total sales made (whether collected or not) less the total expenses incurred (whether paid or not) would equal your company’s net income.
What is the difference?
In general, under the accrual method of accounting you are taking into account your accounts receivable (what people owe you) and your accounts payable (what you owe people) when you are determining how much profit you made for the period being reported.
Let’s look at a very simple example that can help illustrate the difference in net income that is reported under the cash versus the accrual method of accounting:
For the month ended January 31, ABC Company has sales of $100,000 and collected $75,000 with $25,000 still owed to it by its customers. The company also incurred $60,000 of bills but only paid $40,000 and still owed its vendors $20,000.
Under the cash method of accounting, ABC would report net income of $35,000 ($75,000 of actual collections less $40,000 of bills actually paid).
Under the accrual method of accounting, ABC would report net income of $40,000 ($100,000 of total sales less $60,000 of bills incurred).
As stated before, this is a very simple explanation and there are many other differences between the two that would be too complicated to try to fully explain here.
Which is the better method to use?
This can be a difficult question to answer. To do so would require an examination of the specific facts and circumstances of the business in question.
Which method do you need to use?
There may be instances where you do not have a choice but to use one method or the other. For example, you may be required to report your income on the accrual basis under certain bank loan agreements or if the company’s financial statements are prepared in accordance with GAAP (generally accepted accounting principles). There are also certain IRS circumstances where the accrual basis of accounting is required.
Can I change from one method to another?
While you are allowed to change from one method to the other, doing so can create a significant tax issue from a reporting and, sometimes, tax standpoint. Your method of accounting should be determined in your first year of business and will be required to be reported on your fist year’s income tax return. Every effort should be made to look to the nature of and future of the business early on to determine which method of accounting would be preferable before any required regulatory or bank reports are filed as changing your method later, while possible, can present several challenges.