Parts 1 and 2 of this tutorial have introduced the basic principles of cash accounting and accrual accounting.
This part looks at the advantages of accrual accounting which may offset the complexities of administering it. The tutorial also highlights the advantages and disadvantages of both methods and identifies the tradeoffs that are inevitable, no matter which accounting method you choose.
Author: Mike Armour
Even though this tutorial examines a variety of tax issues faced by small business owners, it should not be construed as legal, accounting, or tax advice. Always seek competent professional counsel in addressing issues and questions raised in this article.
Cash Accounting? Or Accrual Accounting?
Which Should You Use?
Part 3 of a Three-Part Tutorial
Advantages of the Accrual Method
From the examples that I've cited, it may sound as though I'm discouraging the accrual approach. But not necessarily. The kinds of tax inequities that we've been describing are usually consequential only for small businesses that have wide swings in expenses and income from month to month and year to year. Where expenses and income are rather steady over extended periods of time, any adverse tax effects usually even out within two or three tax cycles.
And in many instances, using the accrual method will stand you in good stead. If you are raising capital for a company that already has an operating history, investors typically want to see an accrual financial statement, since it reflects the income in the pipeline from receivables. If you are applying for a loan, the accrual method can strengthen your assets on the balance sheet, again because it includes your receivables.
Most of all, the accrual method provides a more accurate and comprehensive picture of your company's true financial position. (This is a primary reason that outside investors will probably ask for accrual financial statements.)
The Trade-Offs in Choosing an Accounting Method
As you can see, there are pluses and minuses for both methods. Whichever method you choose, you must settle for a trade-off.
Besides its simplicity, the primary strong point for cash accounting is its profit and loss statement. The net profit shown on that statement closely replicates the movement of operational cash through the business. The weakness of the cash accounting method is its balance sheet. Since the balance sheet does not reflect receivables and payables, it leaves you with an limited picture of the company's financial position.
The accrual method provides a more accurate and comprehensive picture of your company's financial position.
By contrast, with the accrual system, the balance sheet is one of its notable strengths. The downside of the accrual system is its profit and loss statement. Because of the way it computes net profit, the profit and loss statement may give a first impression of far more money coming into (or leaving) the company than is indeed the case.
Small Business Accounting Software
Fortunately, modern technology allows you to make the best of both worlds and use both methods to monitor your company's progress. Prior to inexpensive accounting software, small businesses had to make a firm choice to record their transactions using the cash method or using the accrual method. Otherwise, they faced the expense of keeping two sets of books, one set for each method.
Today's desktop software packages allow you to use a single set of books to generate both cash and accrual financial statements. To have this option, you must follow the general guidelines from accrual accounting for booking income and expenses.
This means that you post an invoice for all income that you have earned, but for which payment has not been made. And you post the invoice as of the date that you became entitled to payment.
On the expense side you follow a similar pattern, posting a bill whenever your business incurs an obligation for payment at some future date. (That is, you post the bill at the point that you commit to the purchase, not at the point that you receive a statement or invoice from the vendor.)
Then, as customers make payments on your invoices and you make payments on your bills, you post these cash payments as they occur. The software automatically flags each payment transaction so that it can produce financials using either method.
When you ask for financial statements based on cash standards, the software uses the payment dates to calculate income and expenses. It's a process much like balancing your checkbook at the end of the month.
When you ask for financial statements in an accrual format, the software performs a more complex calculation. First it compiles a list of all cash transactions (i.e., income and expenses for which cash changed hands at the point of sale), arranging them by transaction date.
Then it identifies all income transactions in which the invoice date and the payment date are different. Using the invoice date as the transaction date, it sequences these invoices into the list of cash transactions.
Next the software follows a parallel course with expenses. It singles out expense transaction for which the payment date is later than the bill date. Treating the dates of the bills as the transaction dates, it merges these bills with list of cash transactions.
The final step is to add up all income events on the list to obtain total income and all expense events to determine total expense. With these computations complete, the software can immediately generate an accrual statement.
Thus, no matter what method the IRS may mandate or permit you to use in reporting tax liabilities, you can use both methods in parallel to manage and understand your business better.