When I ask a lot of small-business owners if their financial statements are based on a cash or accrual basis of accounting, I typically get a blank stare. Sometimes they reply, “Aren’t all numbers just numbers?”
But when it comes to analyzing financial information to make important decisions in your business, the answer is no. It is critical to understand the difference between an accrual accounting method versus a cash basis one, and to know what information each can tell you about your company.
Accrual-Based Accounting: Examples
What is accrual basis of accounting?
This method records revenue in the profit and loss statement when a sale is delivered or performed for the customer regardless of whether the customer has paid. Expenses are also recorded when they are incurred, even if they have not yet been paid.
An accrual accounting example is performing a lawn-mowing service and then billing the customer who pays in 30 days. The service is recorded as revenue when it is delivered, and the cost to perform the service is also recorded when it is performed. This happens even if the customer has not yet paid for it. The accrual basis of accounting is sometimes called part of the Generally Accepted Accounting Principles (GAAP).
An accrual accounting method most accurately matches revenue and expenses inside your company. You can use this system to closely track gross and net profit margins and the overhead it takes to run your business. This works because these procedures actually match revenue to the expenses required to generate the sales of your company.
Cash-Based Accounting: Examples
This method records revenue in the profit and loss statement when the product or service is actually paid for by the customer, regardless of when it was delivered. Likewise, expenses are only recorded when they are paid for, no matter when they were performed.
A cash accounting example is performing a lawn-mowing service for a customer but only recording it as revenue when they pay their bill. The cost to perform the service is recorded when the employee or contractor is actually paid to do that service.
Most companies should look at their financial statements using both methods and compare results. If there is a drastic difference in the numbers, it tells you to pay attention to the cash flow in your business...
Cash flow is a critical part of running any company. Using a cash basis of accounting will tell you if your company has more or less cash at the end of the month compared to the beginning. In other words, are cash receipts from customers covering the cash expenses you need to pay every month? Cash flow is one of the most vital resources a company has so it needs to be tracked monthly.
Which to Use? Accrual- vs. Cash-Based Accounting
Most small-business owners use both a cash and accrual basis of accounting, and don’t have to exclusively choose (except for which method they will declare when filing their annual federal income taxes every year). If you have a company that is a “pass thru” entity like and LLC or S corporation, where possible, you may want to file on a cash basis since this is the method members and shareholders use to file their personal taxes. Please consult your accounting professional before making a decision.
There are exceptions to using a cash method of accounting: If you have inventory, many companies use an accrual basis of accounting, so their cost of goods matches their sales.
In addition, if you get paid well in advance of delivering your product or services, you may want to use an accrual accounting method since you don’t want to pay taxes on sales you have not yet earned (i.e. a deposit or advance payment can get refunded to the customer).
If you use an accrual basis of accounting, when you're reviewing your profit and loss statement, also run a cash-flow report for the same period of time so you can understand if your company is cash-flow positive or negative. If you use a cash basis for accounting, your balance sheet may not list accounts receivable or accounts payable so ensure that you still run an aged listing for both customers and vendors. For example, an accounts receivable aged listing is important to know who owes you money and for how long.
Remember, you must use the same method for both sales and expenses when looking at a report. It’s as simple as asking your accounting platform to apply the right methodology. Most companies should look at their financial statements using both methods and compare results. If there is a drastic difference in the numbers, it tells you to pay attention to the cash flow in your business since the timing of performing services is different from when you are paid for them.
Read more articles on cash flow.
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