I wanted to start a new series of videos about key financial terms you should know. I believe it’s important to know at least the basics of finance in order to manage your own situation more responsibly.
The first term I’m discussing today is the difference between cash and accrual accounting. Why do you need to know these, anyway, and which should you use for your business?
Check out the video below.
So the first question is, why does it matter?
Firstly it matters because you need to mark your accounting method when filing taxes.
But also, it affects your books in significant ways I’ll discuss below.
It’s a decision best made early on because it can be difficult to switch later on. Especially if you choose cash accounting, it can be rather difficult to switch later to accrual. But if you choose accrual, you can still generate cash basis reports, so that’s one benefit of choosing the accrual method.
With that in mind, which accounting method is better and which should you use for your business?
What Is Cash Accounting?
Cash accounting is the simplest and most intuitive method. It’s what would be most natural to you from handling your own personal finances.
Essentially, you have your paychecks coming in every month, your bills going out, and whatever the difference is is your savings. Money goes out when it goes out, and it comes in when it comes in, and there’s not much more to it.
So when people start a new business, it’s common to carry over this same idea to their business finances. They imagine they have their income coming in every month, their expenses going out every month, and the difference is the profit.
It’s simple, but there are some complications with this method.
What Year Do You Claim Your Income?
Imagine you’ve done some work for a customer at the end of 2022. You send out your invoice in December, but you accept net 30 terms, so your customer doesn’t pay until January.
The question is, do you count that income in 2022, when you sent the invoice, or 2023, when you received the payment?
It’s obviously important for tax purposes. How much money did you make in 2022? It just depends on how you account for it. It might seem unimportant, but being consistent is vital for claiming the right amount of income on your taxes.
How Do You Handle Prepaid Expenses?
Yet another complication of the cash basis of accounting is with prepaid expenses. Let’s say your business makes $10,000 per month. Your rent is $1,000 per month, but you decide to prepay it up front, so pay $12,000 in January for the whole year.
This is a big problem for the cash basis of accounting. You have a massive outlay of $12,000 for rent in January, then nothing else the rest of the year.
Is it accurate to say you operated at a loss in January, since you spent $12,000 on rent but only made $10,000? No, of course not. While you did prepay the rent (what’s called a prepaid expense), it is still effectively $1,000 per month spread throughout the year.
If you want your accounting to be accurate, you’d need to reflect this situation. You’d need to show that you had a rent expense of $1,000 each month, and income of $10,000. Then your profit and loss would accurately reflect your profits each month.
How Much Did It Cost to Generate Your Revenue?
In accrual accounting, there’s a principle — called the matching principle — that says revenues should be recognized in the same month as the expenses that generated them.
So a common example is this: say you have sales representatives you pay 10% commission to. You make $10,000 in January, and so you owe your sales representatives $1,000. However, you won’t actually pay them until February, after you know exactly how much you’ll owe them.
Should you count your commission expense in February, when you actually paid your sales representatives — or in January, when they actually did the work?
If you count it in February, you can’t tell exactly what your profit is. You know you made $10,000 in January, but the expense that generated that revenue isn’t recognized until February, so you can’t directly see what your profit is.
If instead you recognize the expense in January, then you can directly see how much you made, and how much it cost to generate that revenue.
Did You Make a Profit Even Though Bills Were Owed?
One last consideration is, do you count your bills in the period they were received, or the period they were paid?
Did you make more profit this month, just because you neglected to pay your bills until next month? That might seem like a nice way to claim more profit, but it’s far from accurate. That money is still owed, even if it’s not actually paid yet.
The Accrual Basis of Accounting
As you can see, there are quite a few issues with the cash basis of accounting.
In accrual accounting, you count income and expenses when they are earned or incurred, not when cash actually changes hands.
So income is counted when the work is done, the product sold, etc, regardless of whether cash was actually received yet.
If you invoiced $10,000 this month, you count that $10,000 as income in October, and it goes into accounts receivable. You might not get paid for a month or two, or even longer, but that income is counted when it was actually earned.
And similarly, expenses are counted when the vendor did the work, the service was received, you bought the product, etc, regardless of whether you’ve paid that expense yet.
So if you receive a bill this month, you might not pay it for 30-60 days, but you count it this month, and it goes into accounts payable.
In this way, the cash actually changing hands is just incidental to the whole process. The primary event is the bill being received or the invoice being sent.
The one downside of accrual accounting is that it is significantly more difficult than cash accounting. There are things like prepaid expenses as discussed above — or deferred revenue, where a customer prepays you for work not yet done and yet that income can’t be counted until its earned — and many other intricacies to the accrual method.
So obviously I highly recommend using the accrual method, regardless of your situation. Yes, it’s more difficult, but the increased accuracy more than makes up for it. Certain types or sizes of businesses are even required to use accrual accounting, so really there is very little reason to not just use it from the start.
That’s why I suggest that anyone who is starting a business, you hire a bookkeeper to handle these details for you. Then you can benefit from the advantages of accrual accounting, without having to learn all the intricacies yourself.
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