Cash vs. Accrual Accounting
Every business must track transactions to measure its financial results. The accounting method chosen will determine the tax due as well as ownership in the business. For these reasons, it is wise to understand the difference between the two methods of accounting before making that choice.
What it is: A practice that only recognizes transactions when cash changes hands (cash, checks, or bank debits/credits.) A sale is a sale when the customer pays you, a purchase is an expense when you pay for goods, and income is the change in your cash balance for any given period. This method produces only an income statement and is very simple to operate.
Who can use it: Cash-based record keeping is acceptable for service businesses like gardeners, trainers, bookkeepers, etc., or professionals such as doctors and lawyers. Any business that does not carry inventory may elect to operate under cash-basis accounting. Its primary benefit is its simplicity.
What it is: A system of recording every transaction “as it happens” whether or not cash is involved. This includes the recording of events based on the exchange of goods and promises made (purchase and sale agreements), as well as the simple passage of time (interest and depreciation calculations). The intent of Accrual-based accounting is to match revenues received with the costs associated with generating that revenue. Financial statements generated with this method include the income statement, balance sheet, and statement of cash flow.
When to use it: Any business may elect to use accrual accounting, but the IRS dictates that companies carrying inventory must use it. The IRS rule is intended to discourage companies from over-buying inventory at the end of each year to reduce its income (to pay less tax) on the cash-basis. Accrual accounting is also the method sanctioned by Generally Accepted Accounting Principles, (GAAP), which are required for most investors, banks, and valuation calculations.
Book vs. Tax Accounting
Companies that qualify for cash accounting can also elect to use the accrual method. They may also report their results under both methods, using cash-based accounting for tax reporting and accrual accounting for reporting to investors, banks, and management. Most accounting software is capable of producing reports under both methods using the same data. A company has the option to change their tax accounting method from cash to accrual but, once made, cannot be rescinded.
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