What is Cash Accounting?

Many smaller businesses use cash basis accounting when starting out. When cash accounting systems are in place, transactions are recorded as they happen. In other words, income is recorded when a customer pays their bill. This applies whether the business is a small merchant selling goods in a brick-and-mortar shop or a service provider like a plumber or mechanic. When a customer makes a payment, that payment is entered as income.

Expenses are handled in much the same way. When a business receives an invoice, that invoice is simply a piece of paper until it’s paid. Bills owed are not shown on the company’s books until they are paid. Only when the payment is actually sent to the vendor is the amount entered as an expense.

For example, assume an electrical contractor agreed to upgrade a home’s wiring during a remodeling project. The contractor purchased a new electrical panel, wire, and other materials for a total of $2,000. The supplier charged the electrician’s account for the materials and delivered them to the project site. At the same time, the electrician received a deposit from the property owner for $2,500 as partial payment for the materials and the electrician’s labor.

So, how are those transactions entered in the electrician’s books? The check from the electrician’s client would be entered as income, but no entry would be made yet for payment of the materials, as the invoice hasn't been paid. That means, at this point, the electrician would show a profit of $2,500.

If the $2,000 invoice from the material supplier was paid, the net profit would now be reduced to $500. Once the project was completed, the electrician would bill the client for the remaining labor charges. If that amount was an additional $1,000, that amount would not be entered until the customer actually paid the bill.

The cash system is simple for smaller businesses, and the majority of business owners have no problem keeping up with this type of system. Most small business owners use some type of accounting software that’s relatively uncomplicated. Accounting experts generally recommend software that doesn’t include a long learning curve as most small business owners have no desire to delve into complex accounting issues.

How Is Accrual Accounting Different?

The primary difference is when the data is entered. Remember that, under cash accounting, income is entered when a customer makes a payment and expenses are entered when the vendor is actually paid. That changes under accrual accounting. When accrual accounting is used, income is entered when the product or service is invoiced to the customer. By the same token, expenses are entered when an invoice is received, not when it’s paid.

Now, let’s revisit our electrical contractor. If the contractor generated over $5,000,000 of business per year, he or she would be required to use the accrual method of accounting. That means the way the income and expense from a project would be entered differently.

Again, let’s assume the contractor obtained a $2,500 deposit from the client. That amount would be entered immediately as income. Now, the cost of the materials would also be entered as soon as the invoice was received. So, we’re still at the same $500 profit at this point. The difference comes at the end of the project.

Remember that $1,000 additional invoice for labor at the end of the project? It would be entered as income as soon as the invoice was generated even though the client had not yet paid that bill.

If you’re accustomed to cash accounting, using the accrual method will probably appear to be counterintuitive, as the method appears to consider the invoicing to be more important than the actual payments made. However, there are reasons larger organizations typically use the accrual system.

When the Government Gets Involved

Every business is required to file taxes. That means all the financial data collected throughout the year will be needed to report income and expenses accurately. Those businesses that use cash accounting simply look at their totals and use those figures to file their tax forms. Income for the year are the total deposits, profit is the difference between what was deposited and what was spent.

Guess what? Businesses using the accrual system do basically the same thing. But, again, the figures used are based on billings and invoices received, not actual cash. In a way, that may seem unfair, but even if the cash flow isn’t always accurate, the amounts will balance out over time.

The government actually requires larger firms to use accrual accounting, as it’s commonly believed to more accurately portray the overall profitability of an organization. If a business generates in excess of $5,000,000 of sales per year, the organization must use accrual accounting. The use of accrual accounting also makes it far easier to audit a company.

When accrual accounting is used, it’s far easier to determine if a company is profitable over a longer term. That’s vitally important information when there are investors involved who need to know their current investment is safe or if additional funds should be invested in the future.

Understanding Cash Flow

One issue created by using accrual accounting is understanding cash flow. When cash accounting is used, it’s pretty easy to see the business’s cash flow. However, when accrual accounting is used, there is no easy way to determine if a business is actually generating cash.

On the other hand, cash accounting makes it more difficult for outsiders to develop an accurate picture of a small business’s financial picture, as cash accounting skews profit-and-loss issues in the short term. A business can look incredibly profitable one month and yet have no money the next.

CustomWare^® provides Cash Flow Analysis and other reports to help you manage your company's finances. Based on your customer's terms and their average number of days to pay compared with your outstanding vendor invoices and your vendor's terms, you can quickly see your cash flow.

Which Accounting Option is Best for Your Business?

Smaller businesses generally do fine when using cash accounting, and it’s intuitive for most people because it’s similar to the way people track their personal finances. Accounting software geared to cash accounting is also easy to use and inexpensive to obtain.

If you expect your business to cross that $5,000,000 in revenue benchmark, discuss the issue with an accounting expert. While it’s possible to change from cash accounting to accrual accounting later, doing so requires filing additional paperwork.

Most small business owners can easily get by using cash accounting, and they don’t feel intimidated by the nuances of the system. However, don’t hesitate to get professional advice if there are unusual circumstances involved or your company is growing.