Many businesses struggle to determine which accounting method to use in their Financial Statements, Cash or Accrual… Before I try to solve this for your business let’s do a quick refresher to help understand the two.
The Cash accounting method records transactions only when actual cash transactions occur. This includes sales on the Income Statement. A sale may occur and the product or service may be delivered, but if the client has not paid, the sale will not be recorded until the payment is made.
The Accrual accounting method records transactions when they occur, even though an actual cash exchange may not have happened. For sales to be posted into the Income Statement, the sale will be recorded when the product is shipped or service delivered – even if the customer has not yet paid. In the accrual accounting method, when the product is shipped or service delivered without payment a Receivable is generated in the Balance Sheet.
When it comes to choosing which method to use for your business, a CPA will often suggest use of the Cash accounting method, reasoning that this will reduce your tax liability. Companies often will have a big push at the end of the year to increase their sales. If your customer does not pay you immediately, the payments will come in the next year, reducing the total taxes for the current year. The Accrual method would have taxes paid in the current year, even though the cash is actually received in the following year.
On the other hand, the Cash method has several problems when used to operate a business. The biggest problem I found concerns the use of receivables in the Balance Sheet. A receivable is recorded when a sale is made, the product is shipped or service delivered but the customer has not paid. This is common when you extend payment terms to your customer. An example would be a manufacturer selling products to a distributor like a retailer. Retailers typically have payment terms that allow for 30 days to 45 days to pay. In the Cash accounting method, receivables are typically ignored or not recorded as an asset on the balance sheet. Not accounting for receivables can lead the organization to become lax in collecting from their customers – potentially leading to cash flow problems.
The same may also be true of Payables. In the Cash method, Payables, (what you owe your suppliers) is disregarded. This again can cause cash flow issues when a company pays their suppliers too quickly.
The accrual accounting method supplies the company with additional data that does not exist in the cash method. In financials, TMI (Too Much Information) is never true! This additional information from the Accrual method can help a company manage their Cash Flow better.
I would recommend a company always use Accrual accounting method to manage their business. I also do not recommend a company use accrual accounting method for Taxes as they will prematurely pay taxes. To optimize benefits to both methods, I would recommend that Accrual is used for your day to day and month to month accounting when entering data into your financial statements. In most financial bookkeeping software you can switch between each method quite easily, so at the end of a Quarter and end of the year, switch your financial bookkeeping software to cash method when calculating your taxes then switch back to accrual method once the taxes are paid.
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