What is the difference in Accrual and Cash Accounting

Accrual verses Cash Accounting can be one of the more difficult accounting concepts for non-financial people to understand. For the small business owner, every transaction is on a cash basis. They understand revenues and expenses, but what is all this accrual stuff?

Why not just use cash as the method for looking at profit and loss. After all, when the bills are paid, the cash account is checked to see how cash is available.

Accrual accounting records revenues earned and expenses incurred for the specific period. For example, paying the annual business insurance premium depletes cash in the month paid. This insurance is going to cover the business for a 12-month period, but the cash outlay occurs in one month or over a nine-month period.

When trying to obtain a line of credit or a business loan, the bank will ask for the financial statements of the business. The statements will include the Profit & Loss and the Balance Sheet. One thing to remember, a Balance Sheet is always on an accrual basis. Balance Sheets record Assets, Liabilities and Owners Equity, which includes the net worth of the business.

Since the cash basis method of accounting only shows revenues received and deposited in the bank, and expenses paid by cash, check, ACH or credit, the Profit and Loss statement may not fairly represent the business sales and revenues.

Cash Basis may seem simpler to use for the business owner. But using a cash basis can have results that make it more difficult to monitor the business profitability on a monthly basis. While your sales may be booming, your customers may be delinquent in paying. Using the cash method, you may see revenues well under the actual monthly sales. Or the net profit is distorted because there were larger purchases in the given month. Accrual accounting takes these events into account when creating the monthly Profit and Loss statement.

Choosing an accounting method is necessary when preparing the taxes for the entity. The method of accounting must be chosen and stated on the first tax return submitting for the business. When choosing, the method chosen should most closely represent income and expense, and the IRS suggests that the method chosen be used for the business record keeping.

In order to fully understand the difference in accrual and cash accounting methods, refer to my article on Helium.