Cash Basis Accounting Explained
Cash basis accounting only recognises income when it is received and expenses when they are paid. This method of accounting does not recognise accounts receivable or payable as an income or expense.
It is a simple method favoured by many small businesses because it is easy to determine both income and expenses simply by tracking the flow of money in and out of the bank account . The accounting process is not complicated by the need to track accounts receivable or payable.
The process also allows the business to have an exact indication of how much cash it has at its disposal by simply glancing at the bank account balance.
The taxation process is also simplified as income and expenses are only declared when received or paid.
Cash basis accounting is a simple straightforward process.
Accrual Basis Accounting Explained
Accrual basis accounting accounts for income when it is earned rather than received and expenses when they are incurred rather than paid. This method actually gives a truer representation of the business’s overall financial position. It is more commonly used in the cash basis accounting method.
While the accrual based method is likely to give a more accurate picture of the overall business health, the danger can be that cash flow – the lifeblood of any business is not tracked. The accrual basis of accounting may show the business to be running very well when in actual fact there is no money in the bank.
Simply using accrual based accounting without paying attention to cash flow can potentially be catastrophic for a business.
The Effects Of Cash and Accrual Accounting
While an understanding of the differences between cash and accrual accounting is essential it is important that some context be placed around the applications of each method.
The best way to do this is to look at a very simple example like this
Imagine You run a web design business and over the month, the following transactions occur -:
- You complete a major project and issue an invoice for $10,000
- You received a bill for $500 for work outsourced during the project
- You pay $200 to contractors for work performed last month
- $2,000 is paid into your bank account for an invoice that you we should last month
How much profit you made for the month is determined by the accounting method you use
If you used cash basis accounting you would have made $1,800 for the month. On the other hand if you used the accrual accounting method you would have made a profit of $9,500 for the month. The amount of profit would be substantially different but the effect on your cash flow would be the same – your bank account balance will have increased by $1,800
This difference becomes particularly important at the end of the financial year. If these transactions occurred in the last month of the financial year the effect upon taxable income would be significant.
If you used cash basis accounting you would be declaring taxable income of $1,800. If you used accrual-based accounting you would be declaring taxable income of $9,500
How to Choose the Accounting System Suitable For Your Business
Before filing your first tax return you will need to choose the accounting system for your business. The decision is important as you will need to consistently use the same accounting system for the lifetime of your business. Making the right choice will help you manage cash flow and taxation obligations.
Some businesses are required to use the accrual based accounting system. Each business is different and will have its own unique set of variables to consider. For this reason it is best to consult with a trusted CPA to choose the best option for you.