Cash is king, right? Well, yes, but accrual accounting is the queen
If you run a small business, no doubt the concepts of cash vs. accrual accounting probably make you hear elevator music. Probably something like Barry Manilow singing “Feelings….”.While I can’t change the song in your head, let me demystify the confusion.
Cash vs. Accrual Accounting, by definition
Cash-based accounting is the concept where income and expenses are recorded and recognized only when you receive or expend cash; (e.g.) you receive payment from a customer for work performed on their website, or you pay your monthly AMEX bill, or you write a check for new office equipment, etc.
Accrual accounting takes it to the next level by tracking income when the work is performed (and you issue an invoice, therefore recording an accounts receivable) and expenses when incurred (and you receive a utility bill recording it as a purchase to be paid in 30-days, therefore an accounts payable). Cash based accounting does not recognize accounts receivable and accounts payable, because cash has not changed hands. Accrual recognizes events when they are recorded, not necessarily when cash changes hands.
To add confusion, it may not always be an either or decision. For example, you probably want to keep your books on an accrual basis (recording sales when invoiced and expenses when incurred) but your accountant may file your tax returns on a cash basis. At year-end, they’ll make journal entries to create a conversion from accrual to cash (backing out revenue not yet received and expenses not yet paid, to put it simply) so they can file your annual returns. You typically do not need to record these entries.
A few examples
So lets review a few common scenarios and how you may handle them from an accounting perspective;
- When you issue invoices to customers, you are sending them a request for payment. That money owed to you is a receivable, an asset. As soon as you issue the invoice you are recording the revenue (and recognizing it). It remains an asset on your books until it is paid, when it shifts from one asset to another (A/R to Cash). When you are paid 30 days later, you deposit the funds, reduce the open receivable, and life is good. That’s the accrual method and that’s how most small businesses will account for sales.
- If you sell a block of time and take a retainer or prepayment, then the tables are turned – you get paid before you do the work, before the revenue is earned. In these cases, you’d record deferred revenue (aka unearned revenue) and then recognize your revenue as the work is completed. This is a bit more complicated as you’ll want your software to make the necessary entries to move funds from unearned to earned revenue accounts. In your accounting software, just record an Order or Sale with a deposit, even if there is very little information on the services/products provided. If you do this often, you’ll want to look for software that helps you manage these retainer funds correctly. Otherwise, you have a deposit you’ll hold until you finalize the Sales invoices, reflecting the services/products actually sold, with the aforementioned deposit already applied.
- Depending on your type of business, you may bill in stages – with an upfront deposit, a portion near the midway point of the project, then the balance due at the end. In this scenario, it’s important to work out the process of recording your revenue when earned, so perhaps monthly you move funds from your unearned/retainer accounts to earned revenue based on the percentage complete. You’d be doing transactions to reconcile what you’ve billed vs. what you’ve actually done.
- Finally, a different issue you may run into is prepaid expenses, like insurance. Let’s say you pay your annual insurance premium on December 15th for the next calendar year, by prepaying the entire sum up front. When your accountant does your taxes, they will likely include that as an expense this year (since cash is paid this year). In a larger business, they would recognize this expense monthly over the course of the year, again making entries to move the prepaid expense (an asset, or contra-expense) to your insurance expense account in equal monthly amounts.
Books vs. Taxes
You are allowed to use one method for record keeping and one method for tax purposes. Of course your situation will vary and it can get complicated, so be sure to talk to your accountant and bookkeeper and make sure you are on the same page.
Software is your friend
We recommend using your accounting software for what it does best: track all of your transactions, for income and expenses, prepaid or deferred, earned or unearned and let your tax preparer make any necessary entries to file your taxes on the cash basis if that’s what you both determine is best. In the end, you’ll have piece of mind, a realistic set of books, and tax returns that make everyone happy.
Be sure to check out Todd’s fantastic article about questions to ask when it’s time to outsource your bookkeeping!