Probably the financial terms least understood by entrepreneurs are Accrual accounting and Cash accounting. The difference is an important one, especially when you are trying to determine how your business is doing. Let’s define them.
Accrual accounting records a sale when it occurs regardless of when money is collected and records an expense when it is incurred regardless of when payment is made. Cash accounting, on the other hand, records sales when payment is received and records expenses when payment is made.
Why is this important? Your CPA will say the understanding is important for properly reporting and paying income taxes. Most small and medium size service firms report their taxable income using the Cash accounting method. You often hear the term “Cash Basis Accounting” (CBA), which is another way to say Cash accounting.
CBA is simple to implement and maintain.
Your business advisor will say Accrual Basis Accounting (ABA) provides a more accurate picture of how your business is actually doing and this is so. Let’s look at a simplified example of how the two methods work.
Sally developed a marketing program for one of her clients. She completed the work in December and gave her client a bill for $25,000. The bill was paid the following January. Her related expenses of $12,500 were all paid in December.
CBA says Sally lost $12,500 in year 1 and made a profit of $25,000 in year 2. ABA says the income and expenses were all generated in year 1 with a resulting taxable profit of $12,500 for that year.
Which method of accounting accurately presents the results of Sally’s work for both years 1 and 2? ABA presents the income when earned and expense when incurred. Since both happened in year 1, the ABA profit of $12,500 accurately shows that she earned $12,500 for her consulting work.
CBA presents Sally’s taxable picture as though the project spanned two years. In year 1, she had a loss of $12,500 (when she paid her expenses) and a taxable profit of $25,000 in year 2 (when the client paid her bill). You may ask if it actually makes any difference from a tax viewpoint. Probably not. In this admittedly biased case study, Sally runs a risk of paying more tax than necessary. This can happen, but the difference in tax rates is usually small.
From a business perspective, CBA is not helpful for evaluating her operation since it shows income and expenses happening in unrelated years. ABA puts both in the year in which they belong and shows Sally that she did quite well on her project.
Now imagine a business with many items of income and expense each year — your business. CBA makes it difficult to understand profitability from month to month, season to season, or year to year because income and related expenses are not matched. ABA makes it easier to analyze operations and determine how well you are really doing.
There is nothing wrong with using CBA for calculating taxes while using ABA for management purposes. Many businesses use both. This is an instance where two sets of books are not only legal but are also helpful. In fact, important financial analysis can only be performed using ABA. Service businesses can often use a less complex method of management accounting known as Hybrid Accrual. In this method, sales and expenses directly related to sales are reported above the gross profit line on an Accrual basis and general overhead expenses are reported on a Cash basis below the gross profit line in your P&L. You may well benefit from most of the ease of CBA while gaining the management information of ABA by using Hybrid Accrual accounting.
There is no difference between CBA and ABA if you receive payment when service is rendered and pay expenses promptly. In that case, CBA works quite well. The rest of us may benefit from understanding and using some ABA.
Talk to your accountant or business advisor about the methods that are best for calculating your taxes and for managing your business.