Keeping your books on the cash vs. accrual basis is a topic that every business owner must consider at some point. Before we dive into which might be better, lets look at a definition for each.
Cash Basis is easy. You record cash as it comes in and as it goes out. Can’t get much simpler than that.
Accrual on the other hand is a bit more complicated. Revenue is recorded when earned and expenses are recorded when incurred. In theory, this one makes a lot of sense, right? But when it comes to execution, there is a lot more work that goes into keeping your books on the accrual basis.
For the most part, I would recommend just about every business keep their books on the accrual basis internally. If you are a smaller company, it may not matter quite as much. But as you grow and get more complicated, you will want to make the switch.
Let me share a real-life example to drive home the difference between the two.
Lets say you start a job in early February and complete it by the end of the month. You send the client an invoice for $100,000 on February 28. Back in December you bought $75,000 worth of supplies to complete the job. The client pays the $100,000 in early March for the completed job.
Under the cash method you would have $75,000 of expenses in December and $100,000 of income in March. That is when the cash went out and subsequently came in. Easy.
Under the accrual method the $100,000 of revenue and $75,000 of expenses would both be recognized in February. The revenue was earned in that month and the expenses were used up in that month. This gives you a much better picture of what actually happened, right?
Now that you understand the difference, let’s look at the top 3 reasons you would want to keep your books on the accrual basis.
It is important to note that you can file your tax return with a different method then you keep your books. A very common way is to keep your books on the accrual basis and file your tax return on the cash basis. Keep in mind however that once you pick a method for tax purposes, it becomes very difficult to switch later on. You cannot bounce back and forth between cash and accrual basis for your tax return each year.
Comparing your financials month over month can be an incredible tool and very insightful. In order to do this properly, your books need to be on the accrual basis. Your revenue and expenses need to be in the proper months or this type of analysis simply won’t make sense. See the example above to explain why.
Matching Revenue to Expenses
In the example above, I am sure you can see why matching your revenue and expense is extremely important. If you are keeping your books on the cash basis, you will simply record the transaction when the cash transaction takes place. However, if you want a true picture of your financial situation, you need to match your revenue and expenses under the accrual method.
Understanding the past can help you predict the future. Obviously this is never perfect but having a clear picture of the history of your business can pay huge dividends. If your revenue and expenses aren’t reflected in the proper period, this information becomes useless. For example, let’s say you do a job in December but don’t get paid until March. Under the cash method, your March would look great and December would look light.
I understand that some smaller businesses can get away with keeping their books on the cash basis. However, for most other businesses, there really is no excuse to be keeping your books on the cash basis — it just isn’t as effective. You need to be using your financials to make more informed decisions and cash basis financials simply aren’t the answer. In the past I have touched on the idea of “flying blind” by not using your financials to help you make decisions. If you are keeping your books on the cash basis, this is just another form of “flying blind”.
I want to close this post by making one final point. Just because you keep your books on the accrual basis, doesn’t mean you can’t see cash basis financials as well. In fact, there is a big benefit to doing this. However, if you keep your books on the cash basis, there is no way of easily converting them onto the accrual basis. The system simply doesn’t work that way.
I hope this post was insightful for you. If you are still keeping your books on the cash basis, I would seriously question why you are doing that. I am not saying that it is necessarily wrong, but I would encourage you to take a deeper look. As always, I am here to help if you have questions or want to dig into this topic a bit deeper.