One of the most often asked questions I get is “what is the difference between cash and accrual.” Most small business owners DO NOT understand the difference – even after I explain it. It is one of the most confusing topics amongst them. So let me see if I can help a little bit.
The main differentiator between the two is what income is taxable and when as well as which expenses are deductible and when.
Cash basis means you record income as it is received and expenses when they are paid. Therefore all income received is taxable and all expenses paid are deductible – as long as they are business expenses. This is the preferred method for tax purposes because no one wants to pay taxes on money they have yet to receive. And as long as you are under an average of $5 million annual revenue you can use this tax method.* But this is not the preferred method for recordkeeping according to generally accepted accounting principles (GAAP). This method does not give you the true picture about how your business or performing.
Accrual basis means you record your income when it is earned and you record your expenses when you are obligated to pay them. This means that if you sale a $500 product today but the customer does not pay you until next month, you still have to record the sale in this month. Instead of the sale being posted to cash, it will go to Accounts Receivable. The same thing applies for a vendor bill. If you buy job materials today but don’t pay your supplier until next month, you still have to record the purchase as an expense for this month. This results in more taxable income but also more deductible expenses, if your taxes are filed on an accrual basis.*Sorry you cannot stay cash basis forever.
Now if you are a construction contractor, there is yet another method by which you may have to follow. The long term contracts method applies if your business performs services that extend over a period of more than one year. This method allows you recognize revenue and expenses at two different points (1) as a percentage of the job is completed or (2) upon completion of the contract.*
Understanding the difference between these methods, allows you to make better financial decisions about your business. If you are unsure which is best for you, seek advice from your tax advisor or business advisor.
*Please consult a tax advisor for the effects this will have on your business.