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Cash Basis or Accrual Basis: Which should you implement?

Most business professionals understand cash basis and accrual basis accounting on a surface level. However, precious few people have a comprehensive understanding of what each of these accounting terms means and how they differ from one another. Furthermore, understanding these accounting methods is not enough in itself. What matters most is that you implement the optimal method for your unique business.

Accrual Vs Cash

The primary difference between cash basis accounting and accrual basis accounting is in the timing of the recognition of expenses and revenue. The cash approach recognizes expenses and revenue much faster than the accrual method. The accrual approach is more focused on predicted expenses and revenue down the line. Cash basis accounting is centered on recording transactions when cash changes hands meaning it is that much easier to implement.

When Accrual Accounting Makes Sense

If you are looking for a highly accurate representation of your business’s health, the accrual method is best for your company. The accrual accounting method provides an actual representation of your business’ health as it includes both accounts receivable and accounts payable coming through the pipeline as opposed to strictly those that have been completed. This is precisely why more businesses rely on the accrual method of accounting rather than the cash basis approach. The fact that the accrual method smooths out a company’s earnings as time progresses makes it that much more appealing from the perspective of those who handle accounting duties for the top companies in the world.

The Merits of Cash Basis Accounting

Opt for cash basis accounting and revenue will only be reported on your company’s income statements when cash is received. Furthermore, expenses are not recorded until the moment when money is paid. In general, the cash method is primarily used by small businesses. However, cash basis accounting is advantageous in that it is comparably simple, detailing cash that is actually received or paid rather than including transactions that will be finalized down the line. Furthermore, some companies favor cash basis accounting as it makes it that much easier to track the movement of cash, providing company decision-makers with all the information they need to make the most prudent decisions.

Accrual Vs Cash: Additional Considerations

The cash method is not flawless. There is a good argument to be made that using cash basis accounting is a bad idea as it has the potential to significantly overstate a business’s financial health, making it appear as though the company is rich in cash even though it has a considerable number of accounts payables that are significantly greater than the cash currently on the books. A prospective investor could easily analyze a company’s books and make a decision based on cash method accounting that does not portray the truth about the company. In short, it is possible for cash basis accounting to conceal metaphorical financial blemishes, making it appear as though a company is in the black when it is really in the red.

Plenty of businesses favor the accrual method as it casts a larger net, including all relevant accounts payable and receivable information, presenting a clear picture of the company’s profitability, especially across the long haul. As an example, consider a business that has current quarterly sales that would not be recorded through the cash method as revenue won’t arrive until the next quarter. This approach has the potential to make a prospective investor view the company as unprofitable. If the accrual method were used, it would be that much easier for outsiders to understand the company is profitable. However, if tracking cash flow is your primary concern and if you want a simple accounting system, cash basis accounting might be the better option. The bottom line is it will take considerable time, effort, and personnel to practice accrual basis accounting as items such as prepaid expenses and unearned revenue must be accounted for.

Consider Tax Reporting When Choosing Cash Basis or Accrual Basis

Selecting the optimal method of accounting for your company hinges on a wide variety of factors., one of which is taxation. Startups will find cash basis accounting is optimal as it makes the challenge of accounting that much easier, ultimately empowering managers to square their focus on developing a strategic plan for the business. However, if the company eventually goes public, if bank financing is necessary, if the company might be sold down the line or if the books will be audited, there is a good argument to be made that accrual-basis accounting is the better option. It must be noted businesses that are considered medium or large with sales above $5 million across three years must use accrual-basis accounting.

Accrual Vs Cash: Your Company’s Growth Also Matters

Businesses that use cash basis accounting and begin to quickly grow won’t have a crystal clear picture of the company’s overarching performance. Such a business should consider transitioning to accrual-based accounting to get a better sense of its financial standing. However, some growing businesses with considerable seasonal activity will find cash basis accounting is better as it makes the challenge of accounting that much easier when revenue isn’t as high. In the end, determining whether accrual basis accounting or cash basis accounting is optimal for your company hinges on the state of your unique business as well as your goals for the future and the nuanced preferences of your controller, chief financial officer, or other accounting head.

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