Accounting plays a role, in the functioning of any business. It serves as a pillar, for running a business and achieving success.
Yet, every business requires different accounting methods. The accounting style you choose affects how you handle each transaction. Whether it is for bookkeeping, accounting, and reporting purposes. this is where the question of which cash vs accrual accounting method to adopt comes from.
In my experience, I have seen that one wrong decision has led to many things. This includes poor cash flow management, increased tax burden for tax purposes, and even failed audits. Hence, for our clients, I conduct thorough research into their business models. According to my analysis, I suggest the best accounting method for our clients.
In this blog post I aim to delve into the intricacies of each approach. Additionally I will equip you with all the details required for making a informed choice.
“Accounting does not make corporate earnings or balance sheets more volatile. Accounting just increases the transparency of volatility in earnings.”
—Diane Garnick, Chief Income Strategist, TIAA
Key Takeaways
- You must document payments when you make and receive them in cash accounting. We note revenue when we credit money. The same holds true for costs. This remains true regardless of when you rendered or used the service or product.
- Accrual accounting records revenues and costs when they generate or spend them, regardless of when they collect or pay the money.
- The Modified Accrual approach is a compromise between cash basis and accrual accounting, combining simplicity with a comprehensive financial view. The Modified Accrual method takes into account both basic and in-depth analyses of a company’s finances.
- Businesses with revenue of 200k USD or less should adopt for cash basis accounting.
- Businesses with revenue between 200k USD to 5 million USD, should adopt for Modified Accrual method.
- Businesses with revenue of more than 5 Million USD should opt for the Accrual accounting method.
Cash Versus Accrual Accounting Explained
“According to a study by the National Association of State Boards of Accountancy, 78% of small businesses use cash basis accounting. The remaining 22% of small businesses use accrual basis accounting”
When looking at cash basis, you track the money as it comes and goes from your bank account.
Get a payment? Revenue is counted at that time. Pay a bill? That’s when the expense hits.
Simple, Right?
It gives you a pretty accurate picture of your immediate financial situation.
On the flip side, accrual accounting is more intricate. You’re logging income and expenses as they happen, not when the cash shows up or leaves your account.
Say you send an invoice; count that as income before seeing a dime. When you receive bills it’s important to record them as expenses regardless of whether or not you have made the payment
What makes it crucial?
Timing.
You’re noting down things based on actual cash movement on a cash basis. Accrual focuses on economic events, such as selling or receiving a bill, regardless of when money is exchanged.
So you must be wondering why this matters.
Because it does matter!
Each method has its pros and cons. Depending on your business type, one might suit you better. The software tool designs for each method, making your life a tad easier.
Let’s understand each of them:
“72% of small businesses use cash basis accounting.”
-National Federation of Independent Business
Cash accounting records payments as they come and go. The company marks revenue when it credits cash. The same goes for expenses. The timing of the delivery or consumption of the service or product does not matter.
Pros of Cash Basis Accounting
1. Simplicity: It’s easy to understand. You record money when it comes in or goes out.
2. Immediate Cash Flow View: Having an immediate view of your cash flow is crucial for small businesses that operate on thin margins.
3. Less Time-Consuming: Because it’s so straightforward, you don’t need to spend as much time on bookkeeping.
4. Easy to Implement: You don’t need a degree in accounting to get it set up. A simple spreadsheet might be all you need.
Cons of Cash Basis Accounting
1. Lacks Long-Term Perspective: You only see your finances in the here and now, so it can be tough to plan for the future.
2. Not GAAP Compliant: If you want to go public or need to adhere to Generally Accepted Accounting Principles (GAAP) for other reasons, a cash basis won’t be compliant with GAAP.
3. Potential for Revenue Mismatch: You could deliver a service this month and get paid next month, making it tricky to match revenues with expenses accurately.
Accrual Accounting
“In the United States, over 90% of public companies use accrual accounting.”
In accrual accounting, revenues and expenses gets recorded when earned or incurred, regardless of when the cash is received or paid.
Pros:
1. Comprehensive View: A more complete view of your business health is provided, taking into account money owed to you and bills that will need to be paid in the future.
2. GAAP Compliant: If you’re aiming to grow big or already are, this method aligns with what’s generally required for public companies.
3. Better for Planning: Because you’re logging incomes and expenses as they happen, it’s easier to make long-term financial plans and budgets.
4. More Accurate Profit Margins: Accurate recording of revenue and expenses allows for more precise profitability calculation over specific time frames.
Disadvantages of Cash Basis Accounting
1. Complexity: There are more moving parts, like accounts payable and receivable, deferred revenue, etc. That means more time spent on bookkeeping.
2. Potential for Cash Flow Misread: You might see a healthy revenue stream on paper and think you’re doing great, but your actual cash could be low if clients are slow to pay.
3. Resource-Intensive: Typically, you’ll need more sophisticated accounting software or professional help, which could be an issue for a small business.
But what if none of these methods suit your business model?
If none of the above-stated methods suits you, then In this situation, we recommend our client’s Modified Accrual Method of Accounting.
Now you must be wondering:
What is a Modified Accrual method of accounting?
“A study by the Association of Chartered Certified Accountants (ACCA) found that 30% of businesses in the UK use Modified Accrual accounting.”
The Modified Accrual method came about as a compromise between the simplicity of the cash basis and the detailed picture of finances provided by accrual accounting. The Modified Accrual approach considers simple and detailed views of a company’s finances.
How does the Modified Accrual Method of accounting work?
The Modified Accrual method came about as a compromise between the simplicity of the cash basis and the detailed picture of finances provided by accrual accounting. The Modified Accrual approach considers simple and detailed views of a company’s finances.In a Modified Accrual system, the main difference lies in the usage of cash accounting for day-to-day operational expenses, such as utility bills or immediate income like point-of-sale transactions.
You could use accrual accounting for recording revenues and expenses associated with long-term projects or contracts, providing a complete picture of a business’s finances. These are the situations where the cash isn’t received or paid immediately.
This Modified Accrual method also allows for the tracking of accounts receivable, which refers to customer sales made on credit that have yet to be paid.
Who Uses Modified Accrual method of accounting?
Businesses with both types of transactions — immediate and deferred — often find the Modified Accrual method beneficial.
Certain industry practices or regulations sometimes steer a business towards using a Modified Accrual system. Modified Accrual is not accepted under GAAP or for traded companies.
Now let’s understand the pros and cons of Modified Accrual accounting.
Pros and Cons of Modified Accrual Accounting
Pros:
1. Flexibility: Allows you to use cash accounting for some items and accrual for others, giving you the best of both worlds.
2.Tailored Approach: This can be customized to match your business operations better.
3. Moderate Complexity: Easier than full accrual but offers more insight than pure cash accounting.
Cons:
1. Regulatory Hurdles: This may not be allowed for all types of businesses, especially those needing GAAP compliance.
2. Potential for Confusion: Juggling two methods can be confusing and might lead to errors.
3. Increased Bookkeeping: More complex to maintain than either method individually.
But this is individual data; let’s compare all three in a tabular form to understand it better.
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What is the best accounting method for a small business?
Determining the accounting method, for a business involves considering several factors, including the business nature, size and financial objectives. However many small businesses often prefer using the cash accounting method as it offers simplicity and suitability by recording income and expenses when they are received or paid.
Comparing Cash vs. Accrual vs. Modified Accrual Method of Accounting
Here’s a detailed comparison of Cash and Accrual accounting methods, complete with examples for each:
| Criteria | Cash Accounting | Accrual Accounting | Modified Accrual Accounting | Transaction Examples |
|---|---|---|---|---|
| Basic Principle | Records transactions when cash changes hands. | Records transactions when they get earned or incurred. | Combines elements of both cash and accrual methods. | - |
| Example | You record a $500 sale when you receive the cash. | You record a $500 sale when you send the invoice. | You use cash accounting for daily expenses and accrual for long-term projects. | - |
| Revenue Recording | Revenue is recorded when cash gets received from customers. | Revenue is recorded when it is earned, even if cash has not been received. | Could use the cash method for some revenues and accrual for others. | Sale of $500 worth of goods. |
| Expense Recording | Expenses are recorded when cash gets paid out. | Expenses are recorded when they are incurred, even if cash has not been paid. | Could use the cash method for some expenses and accrual for others. | Purchase of $200 in supplies. |
| Complexity | Less complex; simpler to manage. | More complex; requires a greater understanding of accounting principles. | Complexity varies; one must manage aspects of both methods. | - |
| Cash Flow | Easier to track cash flow. | Does not track cash flow; a separate cash flow statement is often needed. | Easier to track cash for some transactions, but might need a cash flow statement for others. | - |
| Financial Health | May not provide a complete picture of financial health. | Provides a more complete picture of overall financial health. | Can offer a balanced view depending on how methods are applied. | - |
| Tax Implications | May defer income and accelerate expenses to minimize tax liability. | Income and expenses are matched, which might spread out the tax liability. | Flexibility to manage tax liabilities, but must be consistent to meet compliance. | - |
| GAAP Compliance | Generally does not comply with GAAP. | Complies with Generally Accepted Accounting Principles (GAAP). | Generally not GAAP compliant, but closer than cash basis alone. | - |
Transaction Examples:
- Sale of $500 worth of goods:
- Cash Accounting: Record revenue when $500 is received.
- Accrual Accounting: Record revenue when the goods are sold, even if payment comes later.
- Modified Accrual Accounting: Could choose either based on chosen criteria for revenue recording.
- Purchase $200 in supplies:
- Cash Accounting: Record expense when $200 is paid.
- Accrual Accounting: Record expenses when supplies are received, even if payment comes later.
- Modified Accrual Accounting: Could choose either based on chosen criteria for expense recording.
Now let’s understand it with an example
How cash, accrual & Modified Accrual affect the bottom line
Below is a case study that outlines the financial transactions of a hypothetical company, “TechSolutions LLC,” which offers IT services to clients. We’ll use 15 transactions to highlight how these would be recorded under cash-basis and accrual-basis accounting methods.
Transactions for TechSolutions LLC (Over 2 Months)
- January 1: Secured a contract with Client A for services, invoicing them $10,000 payable within 30 days.
- January 5: Received $5,000 for a different completed project from Client B.
- January 8: Purchased office furniture for $1,500 (paid immediately).
- January 10: Paid monthly rent of $1,200.
- January 15: Completed the services for Client A.
- January 20: Received a $500 electricity bill payable by February 15.
- January 22: Paid employees’ salaries totaling $3,000.
- January 30: Received $10,000 from Client A.
- February 1: Provided services to Client C but have not invoiced them yet; the services are worth $8,000.
- February 5: Spent $2,000 on promoting the business.
- February 10: Paid the $500 electricity bill received in January.
- February 15: Purchased computer equipment for $2,000, payment due in 30 days.
- February 17: Paid phone bill of $100.
- February 20: Invoiced Client C for $8,000, payable within 30 days.
- February 28: Received $8,000 from Client C.
| Transaction | Description | Cash-Basis Accounting (January) | Cash-Basis Accounting (February) | Accrual-Basis Accounting (January) | Accrual-Basis Accounting (February) | Modified Accrual Accounting (January) | Modified Accrual Accounting (February) |
|---|---|---|---|---|---|---|---|
| 1 | Contract with Client A | $0 | $10,000 | $10,000 | $0 | $10,000 | $0 |
| 2 | Payment from Client B | $5,000 | $0 | $5,000 | $0 | $5,000 | $0 |
| 3 | Office Furniture Purchase | -$1,500 | $0 | -$1,500 | $0 | -$1,500 | $0 |
| 4 | Monthly Rent | -$1,200 | $0 | -$1,200 | $0 | -$1,200 | $0 |
| 5 | Services completed for Client A | $0 | $0 | $0 | $0 | $0 | $0 |
| 6 | Electricity Bill | $0 | -$500 | -$500 | $0 | $0 | -$500 |
| 7 | Employee Salaries | -$3,000 | $0 | -$3,000 | $0 | -$3,000 | $0 |
| 8 | Payment from Client A | $0 | $10,000 | $0 | $0 | $0 | $10,000 |
| 9 | Services to Client C | $0 | $0 | $0 | $8,000 | $0 | $8,000 |
| 10 | Promotion Expenses | $0 | -$2,000 | $0 | -$2,000 | $0 | -$2,000 |
| 11 | Electricity Bill Payment | $0 | -$500 | $0 | $0 | $0 | -$500 |
| 12 | Computer Equipment | $0 | $0 | $0 | -$2,000 | $0 | -$2,000 |
| 13 | Phone Bill | $0 | -$100 | $0 | -$100 | $0 | -$100 |
| 14 | Invoice to Client C | $0 | $0 | $0 | $0 | $0 | $0 |
| 15 | Payment from Client C | $0 | $8,000 | $0 | $0 | $0 | $8,000 |
| Total | Net Income/Expense | -$700 | $15,400 | $3,800 | $3,900 | $8,300 | $13,400 |
Here are the observations from the above stated example
“In the world of business, cash is king, but accrual accounting is the royal historian.”
Cash-Basis Accounting:
In January, TechSolutions LLC showed a loss of $700, while in February, it reported a net income of $15,400.
Accrual-Basis Accounting:
For January and February, the net income appeared more stable and realistic at $3,800 and $3,900, respectively.
Modified Accrual Accounting:
The Modified Accrual method offered a January net income of $8,300 and a February net income of $13,400. This approach seems to capture more financial activities, providing a balanced view. However, it’s crucial to note that the complexity is higher with the Modified Accrual method as it combines cash and accrual accounting elements.
The choice of accounting method can significantly impact the financial health perception of the business. Modified Accrual accounting could provide a more nuanced view but comes with the added burden of managing the complexity.
However, there are ways to select the right accounting method for your business.
What is the Best Accounting Method for your business?
“Small businesses thrive on simplicity, but complexity sometimes holds the key to growth – that’s where Modified Accrual accounting comes in.”
“Estimately 20% businesses uses the wrong accounting method”
The best accounting method depends on various factors. To simply the process, I suggest going with my favorite approach, which I call the “Revenue approach.”
This means that
- Businesses with revenue less than 200K USD annually shall use the cash method of accounting.
- Businesses with sizes 200K– 5M USD shall use the modified accrual accounting mode.
- Additionally, Businesses over 5M USD shall use an Accrual basis of accounting.
Yes, I know; I have added a Modified Accrual in between. I will come to that later. Let me first explain the logic of my segregation.
If we live in an ideal world of unlimited resources and data, then Accrual accounting is the way to go. However, our world is imperfect. Hence, cash-based and Modified Accrual accounting exists.
For easier understanding, we have divided revenues into tiers.
Let’s understand which accounting method suits which tier.
Tier 1: Below 200K USD
Small businesses below 200K USD generally have little capacity to pay their accountants to spend so much time figuring out which payments belong to which bill & which invoice is for deposit.
The benefit of achieving that level of detail for small businesses is not greater than the cost of accounting. Further, I have seen sole proprietors and small business owners have greater visibility over their numbers, including their annual revenue and financial statements.
Hence, they can visualize them with a couple of bank statements. So, they should not use an accrual basis of accounting. They should rely on a cash basis method of accounting.
Tier 2: 200k to 5M USD
Now, coming to my next tier of 200 to 5M, I suggested Modified Accrual accounting. Now, what is Modified Accrual accounting?
This is the most sold accounting service, and more than 80% of accounting firms perform this service. If you notice, the PNL has three parts: sales, COGS, and operational expenses.
Let’s understand it with an example below.
If you’re an online seller, you need a comprehensive understanding of your business profitability. This includes warehousing fees, transport costs, storage, and other logistical expenses that may apply.
I advise using a systematic approach to track your monthly sales. This system should allocate sales to the month in which the products were actually sold and dispatched.
Remember, you can only consider it a ‘sale’ when the product is dispatched and received by the customer. Otherwise, the money should be classified as a ‘Customer Deposit,’ appearing as a liability on your balance sheet.
Many sellers incorrectly account for sales:
- When payment is received on Jan 31 and dispatch occurs on Feb 1, it is important to account for that sale in February, not January (Deflated Sales).
- If you receive money on Feb 28 but dispatch on March 1, that’s a March sale (Inflated Sales).
- These mistakes usually offset each other but should be corrected for accurate accounting.
It’s essential for businesses like made-to-order clothing companies, which have longer dispatch cycles, to only count a sale once proof of delivery is provided, while keeping the initial payment as a liability.
By being meticulous in your sales tracking and accounting, you’ll gain a more accurate understanding of your business profitability.
When it comes to calculating the Cost of Goods Sold (COGS), it’s essential to do so in proportion to your sales. This entails meticulous accounting of all vendor bills used for purchasing inventory.
To achieve an accurate COGS figure, you should also conduct landed cost calculations. This involves subtracting the units sold multiplied by the landed costs from your inventory and transferring that value to your COGS. Furthermore, any expenses closely tied to your business’s sales can also be considered part of your COGS.
Now, you might wonder how to calculate COGS and inventory for businesses. You can find detailed guidance on this topic in an article we previously published.
You can access that blog by clicking on this link.
Tier 3: 5M USD or above
“Globally, over 75% of public companies use accrual accounting.”
I recommend that businesses with more than $5 million should have accrual basis accounting.
Accrual accounting involves a detailed combination of bills and invoices. An accountant must record bills and invoices in the same month they happened, as we explained in our previous example. Calculating bills for each transaction in a month can be time-consuming due to multiple transactions taking place.
So now, until the gross profit level, we have got the accrual accounting done in Modified Accrual mode. Still, with this 100% accrual accounting, we will also do accrual for the operational expenses. Now, every operational expense cannot be accrued.
Technically, that’s. that is not possible unless you are a multi-million dollar giant. And having an expense budget for each and every line item of your PNL.
For operational expenses, smart accountants use Accruals, Depreciation, and Amortization as their weapons to achieve correct MoM operational expense allocation.
How do you choose the best accounting method for your business?
“Remember, the right accounting method isn’t just about compliance; it’s about optimizing your financial strategy.”
When it comes to selecting the best accounting method for your business there are factors to consider. These include the size of your business the industry you operate in and your financial objectives. It is crucial to seek guidance, from an accountant or financial advisor who can evaluate your requirements and assist you in making the choice, for your business.
Understanding these factors can help businesses choose the method that best reflects their financial health and aids in decision-making. Here are the key factors affecting the selection:
1. Business Size and Complexity:
Smaller businesses, particularly sole proprietorships or businesses with few employees, might opt for cash accounting due to its simplicity.
Larger businesses with more transactions, especially those on credit, often use accrual accounting for a more accurate financial picture.
2. Regulatory Requirements:
Some regulatory bodies or taxation authorities mandate businesses of a certain size or type to use the accrual method. For instance, the IRS requires businesses with annual sales exceeding a particular threshold to use accrual accounting.
3. Stakeholder Expectations:
External stakeholders, such as investors or lenders, may prefer the accrual method because it provides a clearer long-term view of a company’s financial health.
4. Nature of Transactions:
Businesses that deal primarily in cash transactions (like certain retail businesses) might lean towards cash accounting.
Those with a significant amount of credit transactions or long-term contracts may prefer accrual accounting to match revenues and expenses effectively.
5. Financial Goals and Planning:
If a business aims for short-term financial tracking and cash flow management, cash accounting might be preferable.
Accrual accounting is often the choice for a more comprehensive view of profitability over longer periods.
6. Resource Availability:
Cash accounting can be less resource-intensive regarding time and expertise.
Accrual accounting often requires more sophisticated accounting systems and potentially professional accountants.
7. Tax Considerations:
Cash accounting allows businesses to report taxes on received income and deduct expenses when paid. This can delay tax liability.
Accrual accounting might lead to paying taxes on revenues that have been earned but not yet received.
8. Cash Flow Visibility:
Cash accounting provides a clear picture since it reflects actual cash flow for businesses wanting direct visibility into cash on hand.
Accrual accounting, while offering a comprehensive look at financial health, might not always provide immediate insights into cash flow.
9. Flexibility in Recognizing Revenue and Expenses:
Accrual accounting provides flexibility in recognizing revenues and expenses, which can be essential for businesses with seasonal operations or cyclical sales.
10. Industry Norms:
In some industries, it’s standard practice to use one method over the other. Conforming to industry norms can make it easier to compare financials with peers.
11. Long-Term Business Goals:
Businesses widely accept accrual accounting if they want to grow or become publicly traded.
Conclusion
While both methods have merits, the selection typically depends on regulatory requirements, business needs, and financial goals. It’s always a good idea for businesses to seek guidance, from advisors or accountants when making decisions, about the most suitable approach.
Ready to Choose the Right Accounting Method for Your Business?
“Almost 72% small businesses uses cash basis accounting whereas, 28% small businesses use Accrual basis accounting”
Choosing the accounting method is a critical decision that can have a significant impact, on your financial prosperity. Don’t go through this journey by yourself! Me and my team is here to assist you every step of the way and ensure that you make the choice for your business requirements.
Easy and Affordable Accounting
Whether you’re a startup a growing enterprise or an established corporation we possess the expertise to help you make an educated decision and provide affordable bookkeeping and accounting services. Let’s collaborate to optimize your strategy and set your business on the path, to success.
Frequently Asked Questions
When you make an accrual, you record the money spent as an expense. You also record the amount owed as a liability on the balance sheet.
It depends on what kind of financial needs you have. I personally prefer the accrual accounting method.
A company can use the cash method instead of the accrual method when reporting income for its tax return. It can only have a statement showing the changes in income and costs because of the technique differences.
To make a decision about the most suitable accounting method, for your business it would be advisable to seek guidance from an accountant or a financial advisor. They possess the expertise to evaluate your requirements and recommend the method for you.
Absolutely! You have the flexibility to utilize an accounting method, for your business. It can be a choice when you come across transactions that’re more suitable, for cash accounting and others that align better with accrual accounting principles.
Certainly! You have the flexibility to transition, between cash and accrual accounting methods. However it’s crucial to be mindful of tax implications. It would be wise to seek advice, from an accountant before proceeding with any changes.
Accrual accounting is necessary, in the following scenarios;
1. If your business is publicly traded.
2. If you are obligated to submit GAAP statements for any other purpose.
