Officially, there are two types of accounting methods, which dictate how the company’s transactions are recorded in the company’s financial books: cash-basis accounting and accrual accounting. The key difference between the two types is how the company records cash coming into and going out of the business. Within that simple difference lies a lot of room for error — or manipulation.
In cash-basis accounting, companies record expenses in financial accounts when the cash is paid out, and they book revenue when they hold the cash in their hands or, more likely, in a bank account. For example, if a painter completed a project on December 30, 2017, but doesn’t get paid for it until the owner inspects it on January 10, 2018, the painter reports those cash earnings on her 2018 tax report. In cash-basis accounting, cash earnings include checks, credit-card receipts, or any other form of revenue from customers.
If a company uses accrual accounting, it records revenue when the actual transaction is completed (such as the completion of work specified in a contract agreement between the company and its customer), not when it receives the cash. That is, the company records revenue when it earns it, even if the customer hasn’t paid yet. For example, a carpentry contractor who uses accrual accounting records the revenue earned when he completes the job, even if the customer hasn’t paid the final bill yet.
Expenses are handled in the same way. The company records any expenses when they’re incurred, even if it hasn’t paid for the supplies yet. For example, when a carpenter buys lumber for a job, he may very likely do so on account and not actually lay out the cash for the lumber until a month or so later when he gets the bill.
WHY METHOD MATTERS
The accounting method a business uses can have a major impact on the total revenue the business reports as well as on the expenses that it subtracts from the revenue to get the bottom line. Here’s how:
- Cash-basis accounting: Expenses and revenues aren’t carefully matched on a month-to-month basis. Expenses aren’t recognized until the money is actually paid out, even if the expenses are incurred in previous months, and revenues earned in previous months aren’t recognized until the cash is actually received. However, cash-basis accounting excels in tracking the actual cash available.
- Accrual accounting: Expenses and revenue are matched, providing a company with a better idea of how much it’s spending to operate each month and how much profit it’s making. Expenses are recorded (or accrued) in the month incurred, even if the cash isn’t paid out until the next month. Revenues are recorded in the month the project is complete or the product is shipped, even if the company hasn’t yet received the cash from the customer.
The way a company records payment of payroll taxes, for example, differs with these two methods. In accrual accounting, each month a company sets aside the amount it expects to pay toward its quarterly tax bills for employee taxes using an accrual (paper transaction in which no money changes hands, which is called an accrual). The entry goes into a tax liability account (an account for tracking tax payments that have been made or must still be made). If the company incurs $1,000 of tax liabilities in March, that amount is entered in the tax liability account even if it hasn’t yet paid out the cash. That way, the expense is matched to the month it is incurred.
In cash accounting, the company doesn’t record the liability until it pays the government the cash. Although the company incurs tax expenses each month, the company using cash accounting shows a higher profit for two months every quarter and possibly even shows a loss in the third month when the taxes are paid.
To see how these two methods can result in totally different financial statements, imagine that a painter contracts a job with a total cost to the customer of $3,000. The painter’s projected expenses for the supplies, labor, and other necessities are $1,200, so his expected profit is $800. He contracts the work on December 23, 2017 and finishes the job on December 31, 2017. However, he isn’t paid until January 3, 2018. The painter takes no cash deposit and instead agrees to be paid in full at completion.
If he uses the cash-basis accounting method, because no cash changes hands, the carpenter doesn’t have to report any revenues from this transaction in 2018. But say he lays out the cash for his expenses in 2017. In this case, his bottom line is $1,200 less with no revenue to offset it, and his net profit (the amount of money the company earned, minus its expenses) for the business in 2017 is lower. This scenario may not necessarily be a bad thing if he’s trying to reduce his tax hit for 2017.
If the same painter uses accrual accounting, his bottom line is different. In this case, he books his expenses when they’re incurred. He also records the income when he completes the job on December 31, 2017, even though he doesn’t get the cash payment until 2018. His net income is increased by this job, and so is his tax hit.
If you still need help deciding which accounting method is best for your business please contact me and I will be glad to discuss it with you.