Cash vs. Accrual Accounting
Why Your Checkbook Isn’t Enough
Accounting can be overwhelming for many small business owners. Driving revenues, increasing
cash in the bank, and serving clients are typically where the energy is consumed. The result is
that little thought is given to the decision of what accounting method is most appropriate for the
business.
There are two principle methods of accounting for reporting the financial health of any
enterprise: the cash method and the accrual method. When and how expenses and revenues
are accounted for is the largest difference between these two methods. But the information
shown by the methods is different as well, with the accrual method painting a much clearer
picture of the actual results for the period and the financial stability of the enterprise.
Cash Method:
The cash method accounts for expenses and revenue as they are paid or received, very much
like balancing a personal checkbook. This simplicity and familiarity is the reason why many
small businesses utilize the cash method. Below is a chart of how the cash method would
account for the following example.
Peppy Painters were retained on May 25th to paint a house for $10,000. Peppy Painters bought
$1,000 in supplies on May 28th. Peppy Painters was paid a retainer for $2,000 on June 10th and
completed and invoiced the remainder on June 15th. Peppy was then paid $8,000 on July 1st.
As shown above, the cash method only accounts for a transaction once cash changes hands.
The most noticeable benefit of the cash method is that it continually monitors the company’s
current cash position. This knowledge is extremely vital for any business owner. “Cash is King”
remains an appropriate motto for all businesses, and the cash method gives a sense the we are
“watching the cash.”
However, the disadvantages outweigh the advantage. As shown in the example, revenues
earned are not necessarily reflected in the same period as the expenses are incurred. As a
result, June looks like a poor month when in fact it was a profitable one. A second
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disadvantage, which Cathedral has seen become very troubling, is that expenses are not
recorded until paid, thereby not monitoring the accounts payable in a timely fashion. When
cash gets tight, bill payment slows. On the cash basis this is not shown in the financials.
Instead the bank may have cash, giving the false sense that all is well. A similar disadvantage
occurs with receivables. Not tracking accounts receivables can lead to discouragement.
Because the company is working hard, but is paid on account, the cash is not flowing in so bills
cannot be paid. The company feels like it is making no progress when it could be quite
profitable. Timely financing becomes critical in these situations, and the cash flow method will
not give this insight.
Accrual Method:
The accrual method accounts for a transaction when it happens regardless of when cash
changes hands. Revenue is recorded according to the billing cycle of the company which is
when the invoice is created. The invoice creation could occur when an initial retainer is paid,
progress billings are mailed, upon completion of service provided, or when product is ordered.
Expenses should be entered by the date on the bill is received. In our example, if Peppy used
the accrual method then he would account for the revenue in June when the job was completed
rather than May when he was retained or in July when cash changed hands. Below is a chart to
show how the accrual method would account for the aforementioned example.
The accrual method provides management with more visibility into the financial health of the
business. This means they can track not only how much money should be received through
accounts payables and accounts receivables, but also when revenue is truly booked.
Cash vs. Accrual:
Although most business owners track outstanding bills and invoices in some way, the accrual
method utilizes the payable and receivable accounts to track unpaid and uncollected items
within the financials. The use of the accrual method gives a proper report of the income and
expense activity for the period and the balance sheet shows the receipts still to be received or
bills still to be paid. It is the balance sheet that warns of liquidity problems, where the income
statement warns of whether we are profitable. The cash method simply does not give these
warnings.
The cash method allows a business owner to easily monitor available cash. It does not,
however, provide visibility into how profitable current business activity is. For example, a large
influx of cash coming into the business on a certain month makes it seem that, from a financial
standpoint, the business is doing very well. However, this could be a group of outstanding
invoices being paid at one time while actual business activity is slower.
The accrual method addresses this problem by accounting for revenue when the transaction
occurs. It clearly shows what bills and revenues are outstanding, allowing the business owner to
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anticipate outstanding bills against available cash and outstanding invoices against cash needs.
This allows for better cash management, assuming timely payments of invoices and bills.
Cathedral recommends using the accrual method because it provides business owners a
clearer, forward looking financial statement to assist in managerial decisions. The utilization of
an electronic accounting system like QuickBooks or Peachtree removes the additional
accounting work required in the accrual method of accounting. Also, if the accounting is done
correctly, a simple preference change in QuickBooks can produce a cash accounting document
as desired.
Taxes:
Most small businesses use the cash method for taxes, because it allows maximum flexibility for
timing revenue and expenses. Revenue can be reduced by slowing collections and expenses
increased by paying bills. The IRS has rules for proper use of these techniques and tax
avoidance is not proper.
When businesses become large, the IRS rules require that it convert to the accrual method.
Corporations that are not S corporations and partnerships that have at least one non S
corporation as a shareholder are required by the IRS to report with the accrual method. Also,
organizations that have over 5 million in annual revenue are required to make the switch to
accrual accounting. The final restriction is that any organization that sells more than 1 million
dollars annually in inventory is required to utilize accrual accounting for their inventory1. This is
done by determining the inventory’s value and deducting the ending balance of the inventory
account from cost of goods sold account. Every other aspect of your business can be accounted
for utilizing the cash methods.
Cathedral does not practice taxation advice and recommends that companies consult with their
tax advisor. Taxpayers are not to use tax advice to engage in illegal activity related to tax
avoidance.
Articles for Further Reading:
1. Author Unknown. “Cash Vs. Accrual Accounting.” 24th April, 2000.
http://www.inc.com/articles/2000/04/19194.html
2. Author Unknown. “Cash vs Accrual Accounting for Small Businesses”
http://smallbusiness.findlaw.com/business-operations/accounting/accounting-cashaccrual.html
3. Author Unknown “Who Can Use the Cash Method?”
http://www.toolkit.com/small_business_guide/sbg.aspx?nid=P06_1344
.
Phil Clements is CEO of Cathedral Consulting Group, LLC and a Managing Director in the New York
Office. Sharon Nolt is a former Senior Associate and Steven Toal is a Senior Associate in the New
Jersey Office.
For more information, please visit Cathedral Consulting Group LLC online at
www.cathedralconsulting.com or contact us at info@cathedralconsulting.com.
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http://smallbusiness.findlaw.com/business-operations/accounting/accounting-cash-accrual.html
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