One of the more common questions I receive in small business/start-up land is what are the differences between cash and accrual basis accounting – and which one should my business be practicing? A more telling question I get asked all too often is, “can you tell me which type of accounting my company is doing,” to which the only appropriate answer can be“not very good” accounting.
Let’s start by taking a look at the first search result from Google on the two methods:
The accrual basis is a method of recording accounting transactions for revenue when earned and expenses when incurred…A key advantage of the accrual basis is that it matches revenues with related expenses, so that the complete impact of a business transaction can be seen within a single reporting period. Revenue is matched to the expenses that were incurred to generate the revenue.
The cash basis of accounting recognizes revenues when cash is received, and expenses when they are paid.This method does not recognize accounts receivable or accounts payable.
For example, a cash basis P&L will reflect a yearly expense,assume an annual software license or insurance premium, in full when the expense is paid, which will have the effect of making the period in which the expense is paid (ie, cash leaves the business’s bank account) look worse than it really is and additionally, all of the following periods will look better than they should. In an equal and opposite issue; the same problem manifests itself if a client pays an invoice late and two or more payments hit the bank account in the same period. As more and more yearly expenses are paid out at once (or revenues earned in multiple periods are collected in one period) the actual measure of performance becomes less and less reliable, until it ultimately leads to numbers that cannot be relied upon at all.
In this day and age if you don’t know your real numbers you can consider yourself behind your competitors. Accounting when performed in a timely and organized manner is not extremely difficult and the benefits cannot be overstated. A small business or startup owner with a mastery of his accounting and numbers will be able to determine not only their true profitability,but also enjoy predictability in forecasts and data visualization.
While there are many unique decisions owners face day to day, the majority of them will in some way be linked to their accounting and numbers. Ask any auditor (or the Wu Tang Clan) and they will confirm “cash rules everything around me,” however this is not true in choosing an accounting method. When asked who should practice cash-basis accounting the answer is generally very quick and easy – “nobody!” Keep in mind that cash basis accounting removes any level of predictability, hinders financial forecasting/modeling, or even determining monthly performance. Furthermore, it is not possible to find any real value in financial statements prepared on the cash basis.