Accrual Accounting Was Created to Fill Textbooks
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?
“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?