Cash v Accrual by nettTracker

Cash v Accrual by nettTracker

When recording bookkeeping entries, and then later preparing tax returns, there are really two main methods of approach. ‘Cash Basis’ or ‘Accrual Basis’. Without trying to over-complicate this, let’s compare the two.

Cash Basis: In very simple terms the ‘books’ or ‘accounts’ (depending on which side of the pond you live), could be compiled purely by recording all of the business related payments and receipts that had gone through the bank account, appeared on credit card statements, or possibly paid out in cash.

Accrual Basis: There will be some items accounted for in the same way as the cash method, but we are also accounting for income and costs regardless as to whether they have been paid or not. Customer invoices, suppliers bills could be dated prior to the year-end date date, but they may not get paid for a month or two. Nevertheless, we still need to account for them.

However, it’s not quite as simple as including amounts that have not been paid yet. Further adjustments are required to reflect the period to which the income/expenditure relates to.

Prepayments: For example, a bill for insurance may be received halfway through the year that covers the next twelve months. Six months for this financial year, and six for the following year. This is the kind of entry that needs to be ‘Prepaid’, and adjustments made each month so that the correct monthly charge is reflected within expenditure.

Deferred income: Some businesses invoice customers for subscriptions services that could possibly be for five years in advance. Receiving the paid invoice is great for cashflow, but again should actually be reflected in the profit and loss over the next 60 months so that it is in line with the costs associated to provide the service - paying employees as an example. So, the income is ‘Deferred’.

Accruals: If a supplier forgets to send a bill (or is sent late) but a business already recieved the goods or services, an ‘Accrual’ for those costs would be required. On the flip side, a business could have been working on project for some time and not yet invoiced the customer. Income should be accrued, or ‘work-in-progress’ (WIP), adjustments created.

Depreciation: If a vehicle is purchased for the business, or any other expensive items of equipment, they are treated as fixed assets and depreciated over a number of years in line with expected useful life. On a cash basis, the cost of the asset would be written off in the first year.

Which method should you use?

Your accountant or CPA should advise you which is necessary for your business type. Sometimes you will not have a choice. Depending on the country, region, size of business and turnover, it will be mandatory to have the books/accounts fully prepared on an accrual basis.

What are the benefits, pros and cons of each?

Well, let’s just start with ‘cash basis’ accounting. The obvious benefit here, is that it is simple. Money received, money paid, and voila, you’ve pretty much calculated your profit/loss for the year. However, it is unlikely the accounts will report the true profitability of the business. Some months could look drastically different from others. If five years worth of income was received in one year, and tax paid on that value, much more tax could have been paid than was necessary.

True accrual accounting helps to ensure there is much more ‘consistency’ in the values that are reported in the profit and loss on a monthly basis. If you need to prepare regular managment reports for board members, or the bank, they will be looking for consistency and trends in the financial reports. Too many peaks and troughs, and questions will be asked. ‘Why has income dropped?’, ‘why are the costs in this month so high?’. Using a series of adjustments to prepay costs, defer income and account for depreciation every month, the profit and loss should report figures that accruately reflect the way the business is operating.

The downside to true accrual accounting is that more work is involved. Calculating monthly adjustments, creating journal entries between the profit and loss and balance sheet every month, and monitoring and updating schedules so that we fully understand what our total prepaid expense and deferred revenue items are, and the breakdown of fixed assets.

True accrual accounting is made much easier with nettTracker. Taking care of all of the adjusting journal entries, and updating the statements you need to agree to the balance sheet. Month-end made easy.