Ask About Cash vs. Accrual Method
My brother-in-law, who is also my CPA, recently reminded me to start preparing my business's receipts and disbursements for his review prior to the end of this tax (calendar) year. And he added a cryptic comment to the effect that he may change my accounting method from cash-basis to accrual-basis. Can you clue me in to what he's talking about?
Dear Basically Challenged,
Your brother-in-law, the Beancounter, must have learned that your business's gross receipts have grown to exceed $5 million this year. (If so, congratulations!) Or perhaps you recently changed the structure of your business to a C corporation. Or maybe you've started a new division that requires your business to keep an inventory. These are the three most common reasons that the IRS will require your business to use the "accrual" accounting method.
Or maybe your brother-in-law believes, as I do, that the accrual method is the only method that makes any sense at all for any business, regardless of size or IRS rules. The difference between the cash and accrual methods is the element of time...but it's an extremely important difference because, in business as in life, timing is everything.
Under the cash method, you record income when it's received into your bank account and an expense when it's paid out of your bank account. Most individuals use the cash method for their personal finances because it's simpler and less time-consuming. However, cash method can distort your business's financial picture, especially if you extend credit to your customers, and if you buy on credit.
Under the accrual method you record income when it's earned, without regard to when you may get paid for the product or service you sold—and you record an expense when it's incurred, without regard to when you'll get around to cutting a check to pay for it.
While the cash method is quick and easy, the accrual method gives you a much more accurate picture of your financial situation than the cash method. Because you record income on the books when it is truly earned, and you record expenses when they are truly incurred, the income earned in one period is accurately matched against the expenses that correspond to that exact period, giving you a better picture of your net profits (or lack of same) for each accounting period.
With the accrual method, you will typically record more transactions but if you are using computer software to do your accounting (which you certainly ought to be if you're not already) this is not a big concern since the computer program automates much of the extra effort required by the accrual method.
So I heartily recommend that you embrace the accrual method, if not your brother-in-law, with open arms and enthusiasm. You and your business will be glad you did.