All small business owners should know the difference between cash basis and accrual basis accounting. They should also understand that the way these two forms of revenue and expense recognition differ from the way
When a business starts up, it must decide if it will be a cash basis bookkeeper or an accrual basis bookkeeper. That determination is required by the IRS and there are rules about what kinds of businesses can be one or the other. In general, a business can be a cash basis bookkeeper when it does not have inventory. This paragraph is from IRS publication 583 and discusses the rule about determining accounting methodology:
If you need inventories to show income correctly, you must generally use an accrual method of accounting for purchases and sales. Inventories include goods held for sale in the normal course of business. They also include raw materials and supplies that will physically become a part of merchandise intended for sale. Inventories are explained in Publication 538.
So what exactly are the differences between cash basis and accrual accounting?
With regard to revenue recognition, cash basis bookkeepers recognize revenue when they receive it. Expenses are recognized when they are paid.
Companies that elect to use accrual based accounting recognize revenues when they are earned (goods and services are delivered) or when revenue is realizable. Realizable means the company has every expectation that it will be paid for its goods and services in the future. Expenses are accrued when they are incurred, whether they are paid or not. There is a principle in accounting called the “matching principle,” which allows accrual basis bookkeepers to accrue an expense in the same period they accrue the income.
When a lender wants a set of financial statements in order to make a loan, they want something that shows all the income and expenses are that have been accrued, whether you are an accrual basis bookkeeper or not.
If you are a cash basis bookkeeper and use any of the recent versions of QuickBooks for your accounting, the program has a feature that lets you generate a set of financial statements showing your company’s financial position based on accrual accounting. This is the kind of report you should be generating to show lenders (as well as for your own management purposes as it is a more comprehensive set of financial statements).
Whether you are a cash basis or an accrual based bookkeeper or not, lenders will want to see a balance sheet and income statement formatted in an accrual format, a copy of your accounts receivable aging, and a copy of your accounts payable aging. They will want to see all of this generated for the same ending period, so it is wise to print and save a set at the end of each accounting month. They may also want to see a statement of cash flow, but we will reserve that topic for later discussion.
The reason a lender needs to look at you on an accrual basis whether or not you are a cash basis bookkeeper for tax purposes is because they need to see the complete picture of your business. When your accountant prepares your taxes at the end of the year they will make modifications so that your company’s IRS tax return can be completed properly. Your accountant can advise you whether being a cash basis bookkeeper makes sense from a tax perspective if your company falls under the rules that will allow cash basis accounting.
There are different stakeholders in your business: you, the management, any lenders who need to see your financial statements, any vendors who want to see your company’s financial statements so they can make trade credit decisions, and, of course, taxing jurisdictions.
As you think about your accounting methodology, remember that if you are a cash basis bookkeeper, some of the internal and outside stakeholders in your business will want to see your financial condition in an accrual format even though you are not an accrual basis bookkeeper for IRS purposes.
Sam Thacker is a partner in Austin Texas based Business Finance Solutions.
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