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Cash vs accrual basis

by | Jul 2, 2022

Accounting seems simple, at first. It’s just a bunch of transactions and numbers that need to be categorized and reported. But, when you report the numbers is a much bigger issue than you first realize. For simple transactions (like buying a slice of pizza), it’s obvious. The transaction occurs and is recognized when the money is exchanged (for the pizza). But, let’s hyperbolize the situation. What if – you signed a new client in April, did their work and invoiced them in May, then were paid in June. When did you earn that revenue? And, which month should you report it in? You can’t prepare reports until you figure that out. And, as you get into bigger businesses with crazier contracts, those questions get even harder.

‘Cash basis’ and ‘accrual basis’ help define that for us. They explain when revenue is earned and expenses are incurred. And, while that seems like an extreme accounting, math-nerd nuance that you’d never need to know, it’s reflected in your financial reports. Cash basis reports reflect cash basis accounting. And, accrual basis reports reflect accrual basis accounting. Depending on which you choose, the numbers will change on your reports. That might be small changes (like how much revenue you earned in a month) or bigger changes (like Accounts Receivable disappearing off the Balance Sheet). Knowing the differences between cash and accrual basis (as well as the tech limitations) will help you better understand your own financials (and the financials other owners try to flex with).

 

Cash and accrual basis definitions :

Cash and accrual basis are the two main accounting basis. And, these are the two options you’ll see in every major accounting software.

Cash basis: Simply, cash basis records when cash changes hands. You recognize revenue when you receive cash (or, the funds are in your account). You recognize an expense when you pay for it. In the above example, you’d recognize the revenue in June.

Accrual basis: Accrual basis records when an activity/event happens (regardless of when money changes hands). You recognize revenue when you perform the work and it’s earned. You recognize an expense when it’s incurred (even if you won’t pay for it until later). In the above example, you’d typically recognize the revenue in May.

Accrual basis can be an extremely nebulous and nuanced concept tho. The longer you think about it and the more wacky scenarios you try applying it to, the more confusing it’ll become. That’s partially why accounting frameworks like GAAP, IFRS, and ASC 606 revenue recognition exist. For your purposes, think of accrual thru the lens of your business and ignore the thought of complex multi-year, international contracts. Let the accountants worry about all the fringe scenarios that don’t actually exist in your business.

Tax basis: You’ll sometimes hear accountants colloquially reference ‘tax basis’ which is a hybrid of cash basis and IRS tax laws that’s commonly used on small business tax returns. It typically means there was a tax adjustment made and you aren’t following pure cash or accrual basis anymore, but are following the IRS versions now (which are ever so slightly different). You’ll never see it in accounting software.

(Note: technically, cash basis accounting doesn’t have short-term receivables or payables whereas accrual basis does. But, receivables, payables, and why we ever decided that was a good idea is a topic for another day.)

Which should I pick tho?

Many accountants will say accrual is better across the board because it matches activities, gives a more complete picture, and provides more information. But, accountants also take proper accounting for granted. Which one is better for you will depend on your business, your software setup, and your financial processes.

Does your accounting software have enough data? Accounting software isn’t magic. It’s just a software database with some funky math rules. It only knows what you tell it. For example, if you invoice thru your accounting software, then it’ll know when you sent the invoice, how much it was for, what the payment terms were, if it was viewed, and if you’re using an integrated payment processor, it’ll also know when the invoice was paid. And, that’s fantastic. You need all that info to report on an accrual basis.

On the other hand, if you invoice clients outside your accounting software, it won’t know any of that information (unless you specifically add it in) and can’t create proper accrual reports. If your invoicing and, to a lesser extent, bill pay aren’t integrated with your accounting software, you should review cash basis reports. Your info probably isn’t complete enough for accrual reports (and lord knows what assumptions the software is making to fill in the gaps).

Can you wrap your head around accrual? We live in a cash basis world and most people inherently view finances from a cash basis perspective. If you can’t wrap your head around accrual and the concept that it reports activities instead of transactions, stick to cash basis reports. The point of reviewing your financials is to better understand your business. And, if you find accrual confusing, it doesn’t matter how many people say it’s better. Besides, you can always switch to accrual as you get more comfortable with your finances and accounting.

 

Pick one and stay consistent :

The important takeaway here is that cash and accrual basis are clearly different. And, unintentionally flipping back and forth between them can result in different financial reports which can mess with the way you view your business finances. You should pick one and stick with it. Every time you generate a report in your accounting software make sure you’re picking the same option. Staying consistent is more important than picking the ‘best’ option for you because the best is debatable, but consistency and understanding aren’t.

 

Action Item:

 

Log into your accounting software, generate a Profit & Loss report, then switch between cash/accrual and update it. Compare the ‘Net Profit’ on each report. Then, try it with your Balance Sheet and watch Accounts Receivable disappear.

 

PS, this is in no way a deep authoritative dive into accrual. This is the way I’d explain it to a client. True GAAP-compliant accrual is a beast and fully understanding the ins and outs of it is overkill.
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