Understanding Cash Basis vs. Accrual Basis Accounting
What’s the difference between cash basis accounting and accrual basis accounting? One is more straightforward, while the other is more accurate. Here’s how to determine which one may be better for your business.
If you own a business, there’s a good chance that you hire a tax CPA to do your taxes. Since they’re the experts, they can handle your business’ more complicated situations—but they may not understand its nuances because they aren’t involved in its daily operations.
Determining whether to file taxes on a cash basis or accrual basis can hugely impact what you’re reporting to the IRS every year. Learn the difference between these two accounting models to determine the one you should use.
Cash basis accounting
Cash basis accounting is the most straightforward method of reporting. With cash-based accounting, you pay taxes based on the actual cash you’ve received (income) minus the cash you’ve spent (expenses).
Companies that bill customers and receive payment after performing the work, especially when customers may be slow to pay, often use cash basis accounting. These companies are typically service companies (i.e., consulting and professional services) or businesses with few costs other than labor.
Accrual basis accounting
Accrual basis accounting is, strictly speaking, a more accurate way of measuring earnings and the most common way for businesses to do their accounting. It’s also generally required anytime you’re providing financial statements to a third party that’s assessing your profitability.
In accrual-based accounting, the income and expenses captured in a span of time are determined not just by the cash that has come in and gone out. They’re also determined by what has been billed and invoiced, regardless of whether those amounts have been received or paid yet.
Accrual basis accounting ensures you’re adhering to the “matching” principle of accounting—i.e., that you’re accounting for the income in the same period of time that you’re accounting for all of the money spent to earn that income. This is especially important at the end of the year—when income or expenses might fall into the next year if payment is delayed. For example, if you billed a customer or client on December 15, 2020, and didn’t receive payment from them until January 10, 2021, an accrual basis method would account for that income in 2020, even though the cash hadn’t been received yet.
Here’s a simple example of how reporting for a company might work under each approach:
* Under cash basis reporting, the difference of $10,000 in net income would be reported in the following year, when the cash is collected/paid.
When considering cash basis vs. accrual basis accounting for tax reporting, look at the predictability of your cash flow. Under a cash basis method, unpredictable cash flow will make tax planning very difficult and can create large swings in taxes from year to year.
So which one should you choose?
If you’d like to know which model makes the most sense for your tax reporting, we recommend talking to your tax CPA about it. If you’re used to seeing really big swings in income and expenses on your quarterly or year-end financial statements, your bookkeeping may not be properly associating the money you’re earning with the money you’re spending to earn it.
To provide the most accurate financial reporting possible, Syzygy always maintains client books on an accrual basis, so we can give business owners the clearest picture of where the business actually stands, in terms of both cash flow and profitability.
Feeling a little lost? Ask the pros for help! Reach out to Syzygy today to see how we can help you rethink your business’ finances so they support your strategic goals.