In general, cash basis focuses on the bank account, entries are only made whenever there is any form of an economic impact on the business. A good example is the sale of product to a customer for cash or on credit (customer pays you in the future). Cash basis accounting doesn’t require a record of the credit based sale; accrual requires an entry to the books.
Because credit is extended to customers and the business is provided credit from vendors the accrual method is the preferred form of accounting. Very few if any businesses still conduct activities in a strict cash basis environment. OK, I’ll yield to your child’s lemonade stand.
So given the endorsement of the accrual basis by pretty much everyone in the profession, why is the cash basis even discussed when it comes to accounting? Answer: taxes.
Cash or Accrual Basis with Taxes
The Internal Revenue Service allows those businesses with revenues of less than $10 Million the privilege of reporting their profit on the cash basis. This is frequently beneficial to small businesses because their cash profit is usually lower than their accrual profit. Why?
Well the majority of small businesses grow from year to year and this growth typically results in an ever increasing accounts receivable. The increase from the balance in the prior year to the current year is an accrual increase, i.e. the business didn’t collect the money from the customer. Therefore a cash adjustment is made to the bottom line reducing the accrual profit to what the IRS calls the cash profit. Now the business is only taxed on the cash earnings instead of the accrual earnings. The difference is often significant and affects the tax obligation dramatically. Here is an example:
Congress authorized this form of taxation for small business to allow the small business to reinvest the tax savings in the hopes of expanding the economy.
Naturally there is a lot more to this than just the change in receivables. Accounts payable growth has the opposite effect. The receivables are an asset and payables are liabilities. Therefore if liabilities increase the cash adjustment requires an increase of the accrual profit. Other significant cash adjustments for tax purposes include:
- Change in Inventory
- Prepaid Expenses
- Accrued Payroll
- Payroll Liabilities
- Loan Amortization
- Lines of Credit
It is not the goal of this lesson to explain the cash adjustment formula but to introduce to you the concept of cash and accrual accounting.
So why is accrual accounting so much more important or beneficial to a business than cash basis accounting.
Accrual Method of Accounting
The goal of accounting is to record economic activity and report this information back to management for the decision making process. Basically it works like this:
Good Information into the Books of Record = Best Opportunity to Make Good Decisions
The accrual process creates the best environment for good information into the system. For anyone to appreciate accrual accounting I’m going to cite and explain the top five accrual entries.
1) Inventory – The accrual method requires a physical counting of the inventory from one accounting period to the next. This count allows for calculating any lost, missing or stolen items as an additional cost of sales. The inventory’s valuation is also calculated to account for market price adjustments again affecting cost of sales.
2) Accounts Receivable – This single account has the greatest impact with accrual accounting. Any credit extended sales would not be recorded as sales under the cash method until the account is collected. Often the associated expenses of these credit sales are cash purchases and they are recorded directly to the income statement. Think of the salesman’s commission, the service department labor, cost of shipping etc. Yet under the cash basis of accounting the sale isn’t recorded until the amount is collected. There is a mismatch of revenue and costs. In accounting this is referred to as the ‘matching principle’ whereby both the revenue and costs are reported in the same accounting period.
3) Prepaid Expenses – The two most common prepaid expenses in business are insurance premiums and local taxes (real estate, property and revenue). Customarily these are recorded as expenses under normal circumstances. Therefore for cash adjustments they act as if they were expended immediately and reduce the accrual profit. The goal of recording these prepaid expenses as an asset is to allocate the premiums or taxes out equally throughout the accounting periods (monthly or quarterly). This aids in leveling the operational expenses. Expenses will generally run higher as a percentage of sales if cash basis is used as actual sales are recorded on the cash basis of accounting. This distorts the reader’s perception of performance.
4) Accounts Payable – Similar to accounts receivable, payables generally relate to the costs side of determining profits. Mostly related to purchases and outside services, accounts payable is used to record these costs to the income statement under the accrual method. Without accrual accounting the likelihood of matching the cash disbursement (payment) to the vendor for costs drops to about 50% of the time (timing of accounting cycles). Accrual accounting eliminates this mismatch.
5) Accrued Payroll – Most small businesses do more than run a pure payroll (pay for physical hours worked). They offer benefits such as sick time and vacation. As these benefits are earned it is customary to record the expense to the books so the expense is reported on the income statement and the amount owed is a liability. For service based operations this can get to be a significant value each accounting period. Again accrual accounting uses the matching principle to match the actual costs and expenses against revenue.
ACCRUAL ACCOUNTING IS GROUNDED IN THE ACCOUNTING CONCEPT OF MATCHING COSTS AND EXPENSES TO THE ASSOCIATED REVENUE.
Summary – Cash or Accrual Accounting
There are so many advantages of accrual accounting over the cash basis method. The primary advantage is matching of costs and expenses against the associated revenue. With accrual accounting management can take advantage of more accurate financial statements to make better decisions.
Cash basis accounting is strictly used for tax purposes with small business. It is rare to practically non-existent for small business to use the cash basis of accounting for regular reporting purposes. Act on Knowledge.
If you have any comments or questions, e-mail me at dave (insert the usual ‘at’ symbol) businessecon.org. I would love to hear from you. If interested in my services as an accountant/consultant; click on ‘My Services‘ in the footer of this article.