Cash vs Accrual Accounting: Why You Need to Know the Difference

Cash and accrual accounting differ quite a bit, and knowing just how they differ is important to every business owner whether you plan to hire a bookkeeping service Atlanta knows and trusts, or do your own accounting in-house. The main difference between cash vs. accrual accounting processes is in regards to timing; that is, when exactly your sales and expenditures are actually documented and listed in the business records. Each of these key accounting methods has specific characteristics and benefits as follows:

Accrual Accounting

Accrual-based accounting involves expenses and revenues recorded as they are actually earned, no matter when the income is paid or received. The accrual method is preferred by many business owners due to its realistic portrayal of expenses and income in a specific time period. The accrual method is valuable for providing a long-term business assessment and picture. However, its downside is in that there isn’t much cash flow awareness. With accrual accounting, a business might seem profitable even if it actually has an empty or very low bank account. If accrual based accounting is chosen, then it will be important to monitor cash flow carefully going forward.

Cash Accounting

A great many small businesses choose cash accounting due to its straightforward quality and ease of use and maintenance. Cash based accounting acknowledges expenses only when paid and cash income when it is actually received. However, the cash method of accounting doesn’t recognize accounts payable or accounts receivable.

The cash method of accounting makes it easy for business owners to determine when transactions occur. It’s not necessary to track payables or receivables. Cash accounting is also helpful for understanding how a company’s income and expenses affect the bank account. Barring a few exceptions, a cash-basis company’s net profit/loss can be easily reconciled with the increase or decrease to the company’s bank balance. Since company transactions are not recorded until cash is paid or received, business income is not taxed until it is actually in the bank.

Accrual vs. Cash Accounting Business Effects

While an understanding of the nuances of both accrual and cash accounting is key to business savvy, these facts must also be put into context via examining the effects that each method has on a business from year to year. The cash and accrual accounting scenarios each affect a company’s bottom line in different ways.

For example, if a business has invoiced a client for $10,000 in work during a particular month, received a vendor bill for $2,000, paid $150 in miscellaneous fees billed by a vendor in a prior month and also received $2,000 from a client who had been billed the previous month, the effect on business cash flow status would be as follows:

Accrual accounting: Current monthly profit would be $8,000 ($10,000 in income minus $2,000 in fees).

Cash accounting: Monthly profit would be $1,850 ($2,000 in income less $150 in fees).

As this example illustrates, the “appearance” of a company’s cash flow and income stream is directly affected by the choice of accounting method that is used for that business in a given tax year.

Cash vs. Accrual Effect on Business Taxes

If the above business month example took place in the last quarter (November, October or December) of a standard year, the tax year affected would depend upon whether the accrual or cash accounting methods were used.

Each method affects which tax year both expenses and income are recorded. With the accrual basis, a client invoice of $10,000 in November would be recorded in the current year, and taxes would be paid on it even if the payment was received in January of the following year. Conversely, with cash accounting, income is recorded when it is received. With the accrual accounting method, income is recorded when earned (billed).

In Conclusion

Both the accrual and cash methods of accounting have their strengths and weaknesses, and making the most of the type chosen requires an understanding of what specific numbers mean regarding your company’s financial needs and specific questions.

Ultimately, each accounting method only offers a portion of the complete picture of a business. Selecting the best method will probably be a changing and ongoing process as your company grows and evolves. Also, it should be noted that some business types are actually required to employ the accrual-based method of accounting. Contact a bookkeeping service Atlanta trusts to find out what’s required of your business.

If you’re still not sure about whether the cash or accrual accounting method is ideal for your company, consult with a professional bookkeeping firm in Atlanta, GA. They will help you to feel confident that you’ve made the very best decision for your business. Professional accounting in Atlanta can also provide continued strategic advice to support your business optimally as it grows, evolves and thrives.

Store or Destroy? How Long to Keep Financial Records

Keeping proper records for the right amount of time is confusing for many small businesses. Some wind up not holding onto financial records long enough. Others hold onto every scrap of paper that looks like it might be important someday, and they keep holding it like a security blanket. Few things need to be kept forever. What’s important is to keep things organized and to hold on to the receipts, statements, and documents that are the most important.

Staying Organized

Beyond deciding what to keep and how long to keep it for, there is the issue of how to keep everything organized. One big drawer or box labeled “Important” is not going to be sufficient. Have set categories for files. Popular categories include

  • Operating Expenses
  • Invoices
  • Clients
  • Payroll

Depending on the nature of your business, there may be different or additional categories to consider. A good bookkeeping service in Atlanta will be able to talk to you about the nature of your business and help you organize your records so you have a strong sense of what is going on with your business and so that you are ready for tax time or any business changes you decide to make.

In addition to categories, files can be labeled according to the year of origin as well as an “expiration date” which will let you know when it is okay to shred the record and make room for transactions of the future.

Deciding What Financial Records to Keep

Tax Stuff

The decision of what to keep and for how long depends on a lot of different factors. IRS requirements are near the top of every business’s priority list, because the possibility of an audit always exists to some extent, and you want to be prepared. Tax records are anything that shows evidence of income or supports your qualification for a credit or deduction on your return.

Income related documents include

  • W2s and 1099s
  • Invoices
  • Credit Card Charge Slips
  • Cash Register Tapes

Some things that support tax deductions are

  • Mileage logs
  • Canceled Checks
  • Receipts for purchases
  • Receipts for charitable contributions
  • Credit card slips and statements
  • Invoices

In most cases, tax records are kept 3 years from the filing deadline or the time the taxes were actually filed and paid. This time frame is standard because it reflects the period of limitations. It is during this time when tax returns can be amended and the IRS can assess additional taxes.

The three year rule does have some exceptions. Records that show evidence of a bad debt deduction or a financial loss from a worthless security should be kept for 7 years. Tax records that reflect unreported income that is at least a quarter of your gross income need to be retained for six years. Employment tax records should be kept for at least 4 years after the date they are paid or the due date, whichever is later. Some recommend that filed State and Federal Returns remain in your files for as long as 6 years.

Property Records

The ownership of property has tax implications, of course, but it is also something that is looked at a bit differently that other types of tax records. As long as you own the property, you should keep any deeds or titles that show that. If you sell the property, you will need to report the sale on your next tax return. Physical as well as intellectual property both count. After that return is filed, keep those records another 4 years. Because the value of property can fluctuate, keeping the records will assure that you have what you need to calculate what type of gains or losses you incurred with the sale.

Insurance and Credit Records

The need to hold onto insurance records or credit records such as loan agreements can depend on the companies you are working with. Some want you to hold onto records longer than the IRS. Make sure you check with these companies before you decide to discard anything. If you have an active policy or open credit account, you’ll want to keep the original agreements as well as recent statements.

Things You Can Discard

In addition to shredding documents that are old enough to be considered expired, there are also even more temporary documents that can be discarded even sooner. ATM receipts and deposit slips are things some people keep just to make sure that they are being properly credited for their transactions. Usually, there is a more official record of these transactions within a few days on your bank statements. Once you see this, the actual receipts and deposit slips can be shredded and recycled.

In most cases, it is not necessary to keep each and every bank statement. Transactions on a monthly statement will carry over to a quarterly or year end statement. Keep whichever statements carry the most information, and shred anything remaining. Actually tossing some things will help you keep your records clean and organized and make life easier for you, your bookkeeper, or accountant.