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“Accrual accounting was created to fill textbooks”

by John Coates  |  December 9/2010  |  , , , ,

“Accrual accounting was created to fill textbooks” said a CPA (Certified Public Accountant) I was chatting with on a recent road trip. Essentially, since accrual accounting is more complicated than cash basis accounting, it fills up more space in textbooks, justifying their length. The CPA further went on to say that most of his clients, big and small, use the cash basis of accounting – it’s simpler and allows them to run their business.

Slow down – what’s accrual and cash accounting?

Wikipedia states:

“Cash basis tax payers include income when it is received, and claim deductions when expenses are paid”

And accrual accounting is:

“Accrual basis taxpayers include items when they are earned and claim deductions when expenses are incurred”.

So, what does that mean?

Accrual accounting is what publicly traded companies follow and is can be traditionally referred to as GAAP – Generally Accepted Accounting Principles. For a service-based business, this means you recognize (account for) revenue and expenses when you perform the action, as in do the work, or receive service from an expense (Matching Principle). However, you have not necessarily received payment for, or paid for, the service.

For your business, it means recognizing the revenue when you send the invoice because the work is complete. Sound simple? It’s simple until you do your taxes. For example, if you do not get paid for an invoice, and since you already counted the revenue, you get taxed against it. However, you subtract it from your earnings using a “bad debt expense” so you only get taxed on your profit. Additionally, because you do not know who will pay you or not, your accountant has to estimate it every year. Basically, it’s an added complication. Another example is if you pay for a service beforehand such as insurance. It’s actually not an expense until you use it in the future.

Cash basis is a lot simpler — it’s all about cash in and out. This means you count money in and money out when you get it – much easier to keep track of. It’s a lot simpler for your accounting. It also represents where your cash and business actually is. So if you received payment of $100,000, in a year, and paid out $20,000 in expenses, then your profit is $80,000 – simple.  So you can see that it might be best to keep it simple – remember, you love what you do.

Lastly, at a certain company size, you may need to switch from Cash to Accrual basis. I highly recommend talking to your accountant about it, but keep in mind, the CPAs I’ve talked with all have stated that even companies with millions in revenue and 20 staff, you can and maybe should still use cash basis accounting.

What do you use? Cash or accrual accounting?

  • Eric Matthews

    This was a very interesting post John. I can honestly say I have never thought about using the cash basis before, or worked for someone who did.

    I think it would be useful for businesses with cash flow problems. It’s so easy to see profits on paper, but overdrawn bank accounts in reality. The cash basis would ignore your uncollected receivables, which is where you can sometimes get lulled into a false sense of security.

    On the other hand, the cash basis can also cause a lot of confusion. If I buy materials this month, but don’t pay for them until January, then my profits for this year are overstated. If I needed a tax break, I’d just get my December customers to pay me on January 1st to avoid claiming the income.

    Thank you for writing this. It’s really got me thinking about a method I’d previously discounted. I might write something about this on my site as well.

  • John

    I think the quoted CPA was being simple minded. Just as Eric mentions above, accrual accounting (for tax purposes) prevents manipulation of the tax obligation for a year simply by buying stuff early, or collecting payments late. It wasn’t created to fill textbooks, it was created because it more accurately represents reality.

  • Steve Nims

    I’m fairly certain that tax laws recognize the income in the period the service is performed, regardless of when a business receives payment for said service for exactly the reason you just stated.

  • Anthony DeLorenzo

    I’d use cash basis if I could, but I can’t. Why not?

    Revenue Canada requires you to use accrual accounting, even if you are a self-employed individual. Something your Canadian readers should probably know.

  • John Coates

    As mentioned in the comments – cash basis can be abused to overstate income, and understate expenses based on timing. In most cases for independent serviced based businesses, this may only create a swing of a few thousands dollars and needs to be maintained every year (more of an issue for public traded companies).

    However, based on your legal entity (if you’re a corporation or not), you will have different tax responsibilities. Please consult with an accountant when needed.

  • Mark

    Cash is very appealing, especially for very small companies and freelancers because your tax liability is not going to exceed the money you have on hand, which can only be good, right?
    Right! People pay me, I pay the government – great!
    However it is a poor way to gauge the position and health of a company. If you owe others a lot of money, that doesn’t show in the cash view of things. If your debts vastly outweigh your receivables, then you’re in trouble, maybe not today, but at some point you are going to need to pay what you owe. Whether you recognise revenue and expenses on a cash or accrual basis, you still need to pay and get paid. Cash and accrual give the same end result, they differ only in the timing – the crucial difference is accrual will tell you what is going to happen in the future, and cash can only explain what has happened in the past.

    So while I think this is a good topic and relevant for the freelancing community to understand and discuss with their advisors, cash basis is not a silver bullet that will make your business dreams come true, and accrual accounting does not just exist to keep CPA’s busy and textbooks long. I would certainly disagree with “It also represents where your cash and business actually is.”
    Cash basis is a useful way to calculate your tax obligation to authorities and to ensure you have the cashflow to cover that obligation but it’s inappropriate to generate the rest of your reports this way. Where your business really is means factoring in your non cash transactions. A business with a million dollars in the bank is still insolvent if they have two million dollars outstanding liabilities to others.

    A good accounting system should give you the best of both worlds, running most reports on accrual basis, but allowing you to to run your tax reporting on either basis. If it’s done properly, you should never need to worry about your basis day to day, you just key data as you would normally and reports will show in the most useful form.

  • Mathivanan

    Accrual accounting and accounting standards make the financial statements complex ,difficult to understand, interpret and limit the usage

  • Chris S.

    I have used accrual accounting for years and ran into a lot of troubles with that. Things like credit card bills and cel phone bills that don’t fit neatly at the end of the month and may straddle two months are difficult to account for properly. I’ve recently switched to cash based accounting for my current fiscal year and already feel relieved! Cash all the way!!

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