Cash Basis vs. Accrual Basis Accounting

When you are starting a new business, accounting may be one of the last issues on your mind. However, when you are getting setup for the first time, it is important to think of the long-term consequences of your accounting method.

 

Cash Basis

Cash basis accounting works like it sounds, you recognize income and expenses as you receive and spend the cash. When money comes in, it is recognized as revenue, when money is spend, it is recognized as an expense.

For most small businesses, cash basis accounting makes the most sense. Matching your cash flow to your accounting periods is by far the easiest way to track your income and expenses.

 

Accrual Basis

Accrual accounting is more complex, but can lead to better tax situation for larger companies. In accrual accounting, all revenue and expenses are matched to the period when the service takes place.

To really understand how accrual accounting works, let’s use a concert planning business as an example to help you understand how it works.

When you plan a concert, some of the cash is received months before the date of the show, cash trickles in as the show approaches, and some people buy the day of the show.

Expenses are also incurred over a long period of time. Some expenses are paid months ahead of time, and some are paid after the show. The expenses for a major event can easily cross multiple months. For a show in December or January, expenses, or revenue, can easily cross into multiple years.

If you are a cash basis business, you may have to pay taxes on the revenue on one year’s taxes and deduct the expenses the following year. That doesn’t make sense when you know the expense is coming.

To adjust for that, the IRS allows you to recognize all revenue and expenses in the same period. It has to be the period when the service took place. To ensure your tax reporting matches the actual revenue and costs, you (or your accountant) accrue for the revenue and expenses. An accrual is an accounting entry that acts as a placeholder on your books.

 

Accounting Periods

For some companies that are seasonal in nature, it could make more sense to operate on a cash basis but adjust your fiscal year.

Most companies use the calendar year for tracking business revenue and expenses. According to IRS rules, companies are allowed to adjust their fiscal year as long as it is consistent and defined.

Companies that are very busy during the holiday season, for example, may want to have a fiscal year that begins July 1st rather than January 1st so they don’t have to worry about year-end accounting during their busy season.

 

How Should You Deal With Accounting?

That is best decided by you and your accountant. Make sure to really understand the implications of your accounting method and plan out to decide what is best for your business, especially since many free online accounting programs don’t always allow you to choose what method of accounting you prefer.  Only complex accounting programs like Quickbooks let you choose.

About Eric Rosenberg

Eric is a finance blogger at Narrow Bridge Finance and a serial entrepreneur. He runs a media company, flash mob company, and DJ business from his hometown in Denver, Colorado. You can read more about his finance background and connect with him around the web.

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