LOU currently only tracks accounting using the Accrual Basis method.
Cash Basis in the Future
In the future, LOU may give you a choice between Accrual Basis and Cash Basis Accounting.
What’s the difference between Cash Basis and Accrual Basis Accounting and why does LOU use Accrual Basis Accounting? Let’s compare the two and take a look!
Cash Basis Accounting
Cash Basis recognizes revenue when cash is received and expenses when they’re paid. It’s “instant”. This method of accounting does not recognize Accounts Receivable or Accounts Payable.
The Cash Basis method of accounting is useful for small business where it’s easy to determine when a transaction took place and there is no need to track receivables or payables. It’s simple to maintain. Since transactions are not recorded until the cash is received or paid, the income is not recognized until it’s in the bank.
Accrual Basis Accounting
Accrual Basis is more commonly used than Cash Basis. Accrual Basis recognizes revenues and expenses when they are earned, regardless of when the money is physically received or paid. You would record the revenue upon project completion, not upon receipt of payment for the project.
Accrual Basis Accounting provides a better long-term picture of the business because it’s a more realistic idea of income and expenses over time. However, Accrual Basis doesn’t provide any awareness of the actual cashflow of a business. The business may appear highly profitable when there is no money in the coffers. Relying upon Accrual Basis Accounting without diligently monitoring the cashflow can have devastating consequences to the business.
Context for Comparison
Louie’s Outdoor Living logged the following transactions:
- Invoiced customer for $5000 hot tub install completed this month.
- Received invoice for $1000 from the hot tub vendor this month.
- Paid $75 to a vendor for an invoice from last month.
- Received $1000 from a customer for an invoice from last month.
Effect on Cashflow
Looking at the Cash Basis Accounting method, the profit for this month would be $925. You took in $1000 and paid out $75, leaving $925.
Looking at the Accrual Basis Accounting method, the profit for this month would be $4000. You invoiced $5000 and were billed $1000, leaving $4000.
You can see how Accrual makes your income look higher than the actual cashflow. With Accrual Basis Accounting, you are recognizing income before you have the income.
Effect on Taxes
Imagine the current month in the example is December and the previous month is November. One of the differences between Cash Basis and Accrual Basis Accounting is which tax year in which you recognize the income and expenses for these transactions.
Using Cash Basis Accounting, you record the income when you receive it. If you invoiced the $5000 project in December and the customer paid it the same month, you would recognize that income and pay taxes on it for that year.
Using Accrual Basis Accounting, you record the income when you invoice it. If you invoiced the $5000 project in December, you would recognize that income and pay taxes on it for that tax year even if the customer doesn’t pay you until January of the following year.
Which Method Should a Business Use?
If a business is a corporation other than an S-corp that averages more than $25million in gross receipts each year, the IRS requires the business to use the Accrual Basis method.
If the business does not meet that criteria, they are free to use the Cash Basis method.
The Cash Basis method typically works best for small businesses without inventory. Accountants commonly recommend Accrual Basis Accounting to business that are inventory-heavy.
Online Resources
These are publicly available online resources Evosus finds useful. We do not control the information on these third party sites.
https://www.investopedia.com/ask/answers/09/accrual-accounting.asp
https://quickbooks.intuit.com/r/bookkeeping/cash-vs-accrual-accounting-whats-best-small-business/
https://www.accountingcoach.com/blog/cash-basis-accrual-basis-of-accounting
https://www.khanacademy.org/economics-finance-domain/core-finance/accounting-and-financial-stateme/cash-accrual-accounting/v/comparing-accrual-and-cash-accounting