Ready for a round of CFO Consulting Topics? This month, we’re tackling a key question for small business owners everywhere:
What’s the difference between Cash Basis Accounting and Accrual Basis Accounting?
Both the cash basis and accrual basis of accounting are acceptable approaches to bookkeeping, and in many instances, cash basis is the preferred way to record transactions for tax purposes, especially for small business owners.
The accrual method is the proper Generally Accepted Accounting Principles or “GAAP” way to record your books and is required for publicly held organizations.
If you are a small business owner currently employing the Cash Basis Accounting method, below are a few key CFO consulting insights on how Accrual Basis Accounting can be applied in small business situations.
About Cash Basis Accounting
Cash basis accounting is the methodology of tracking your business receipts and expenses as you pay for them. If you receive money for your goods or services, you record revenue when the money is received regardless of when the services were delivered to your customers.
Likewise, you record expenses when you pay them, regardless of when you incurred those expenses.
How to Approach Accrual Basis Accounting
With accrual basis accounting, you record revenue when the service is delivered. You may have customers that you perform services for on a subscription basis (monthly retainer). These customers are typically billed monthly and that is when the revenue is booked, regardless if your customer has paid for the service.
Accrual accounting also records expenses in the period incurred, regardless of when they have been paid. If a company has received a service from a vendor, the expense associated with that service is recorded as accounts payable or accrued liabilities in the period the obligation was incurred.
That’s not all.
Taking the accrual accounting concept even further, if something is paid for in full, like an annual insurance policy for liability insurance, the proper way to account for this is to record the entire payment in a prepaid asset account when paid and expense the monthly portion and reduce the asset each month of the year.
Other items that should be recorded as an asset — or potentially recorded as a deferred liability account — and amortized monthly would be customers who have prepaid for a service or who have been required to make a deposit.
If a customer pays for a three-month service in full when the contract is signed, the proper way to record this is to establish a deferred revenue liability account or customer deposit asset account for the entire amount and reduce the balance each month while recording the appropriate revenue.
Here is how it would be recorded (customer prepays for 3 months of service for a total of $6,000 or $2,000 per month):
- At contract signing and receipt of 3 months of service: Debit cash $6,000 and Credit $6,000 deferred revenue liability
- When the first month of service has been provided to the customer: Debit deferred revenue liability $2,000 and credit customer revenue $2,000
When Should Small Businesses Use Accrual Basis Accounting?
There are many more complex transactions that require analysis and estimates (bad debt reserves, warranty liability reserves and tax estimates to name a few).
If you record obligations as expenses and liabilities when incurred, record revenue and accounts receivables when the service has been delivered and the value has been determined, you will be well on your way to properly recording your books on the accrual method of accounting.
If you have a business that is growing, and you are thinking about bringing on investors or potentially thinking about selling your business then the accrual method of accounting is the proper method to use. ChoiceFinance’s CFO Consulting services can prepare your business for these next steps.