Accrual vs. Cash Basis Accounting
Is a sale considered income when you bill it to the customer or when you collect the payment? The answer to that question depends on which method of accounting you use.
- If you use the accrual method, your sale becomes income when you earn it, or in more practical terms, when you invoice it. Even if you have not yet collected the payment you would recognize the income on your books.
- Using the cash method, you would recognize the income when you collect the payment, regardless of when or if it was invoiced.
This logic also applies to expenses. Under the accrual method, an expense is recognized as such when it’s billed to you, whether you have paid that bill or not. Under the cash basis, the expense is not recognized until it’s paid.
So which method should you use?
If your business invoices customers and purchases materials or other items on terms from your vendors, the accrual method gives you a more complete and accurate picture of how your business is really doing. Say you have customers who are slow paying but you always pay your bills on time. If you wait until you are paid to recognize the income (using cash basis accounting) your profit will be understated. This may be a good thing when you’re getting ready to file your tax return and want to show as little profit as possible*. But if you are submitting your financial statements to a bank for a loan application, or if you just want to know if you’re making money, you’ll need to use the accrual basis to get the real picture.
On the other hand, many small businesses run on a strict cash basis. They collect payment at the time of service and have no accounts receivable. They pay for materials with a credit card or check at the time of purchase and have no accounts payable. If this is the case, cash basis books are in order.
The good news is that QuickBooks will easily convert your books from cash to accrual with the click of a button. So at the end of the month, when you want to see how you did you can run a Profit and Loss Report using the accrual basis. And when it’s time to file your taxes, you can easily switch to cash basis and run the same P&L report. Click here for a tutorial on setting and switching your accounting method in QuickBooks.
*NOTE: Not every business files its tax returns in cash basis. You can elect to file your taxes using the accrual basis. Once you start with one method, however, you have to stick with that method per IRS rules. You should consult with a tax accountant to determine which method is right for you.