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Accrual or Cash Basis Unveiled: Your Guide to Future-Focused Bookkeeping

Updated: Feb 19

Dear Fellow Business Enthusiasts,


It's accrual world. While this phrase may carry a touch of cringe that could easily adorn a t-shirt (which, I am 100% not admitting to having in my closet), there's an undeniable truth that underlies its charm. When delving into the realm of business, one of the foremost decisions is the accounting method you choose to embrace: cash or accrual. The good news is, the latter tends to be the wiser path. Although the allure of cash accounting might be strong, opting for the accrual method presents itself as the more prudent choice, sparing you a world of unnecessary headaches.




The principle of conducting accounting through an accrual basis holds steadfast across a myriad of businesses. Cash basis accounting involves recording transactions only when physical money changes hands. While this may appear as the obvious approach, let's consider an alternate perspective to better understand the potential limitations of this method.

Imagine overseeing a modest retail establishment specializing in electronic gadgets. Your operational foundation relies on cash basis accounting, meaning transactions are documented exclusively when cash is exchanged. Let me provide you with a glimpse into how this setup could potentially lead to complications:

Accoiunting equation

November arrives and preparing for the holidays and so you embark on a significant bulk purchase of cutting-edge gadgets from a supplier, with the intention of launching sales in December. The invoice for this acquisition amounts to a substantial $10,000, with a payment arrangement spanning over a 60-day period. Despite November passing by, your financial records remain void of any expense entries associated with this acquisition, due to the pending payment.

Fast forward to December, where two distinct scenarios unfold:

Scenario 1: Cash Basis Accounting As December begins, your gadget sales take off, accumulating an impressive $15,000 in revenue. In alignment with your cash-focused approach, sales are logged only upon cash reception. By the end of the month, your coffers hold $5,000 in cash received from customers. A snapshot of your finances for December, adhering to cash basis accounting:

  • Sales: $5,000

  • Expenses: $0 (due to the pending $10,000 expense from November)

  • Net Income: $5,000

Scenario 2: Accrual Basis Accounting Embracing the principle of accrual basis accounting in November you appropriately recognize both revenue and expenses when they are incurred or earned, regardless of the timeline for cash exchange. A financial overview for December, grounded in accrual basis accounting:

  • Sales: $15,000 (acknowledged at the time of sale)

  • Expenses: $10,000 (recorded in light of the November expense)

  • Net Income: $5,000

Under the cash basis accounting approach, your business's financial position for December becomes inadvertently distorted. Despite making a significant $10,000 purchase in November, your accounting system fails to reflect this expenditure until the actual payment is processed, sometime in the new year. Consequently, your net income appears artificially inflated by $5,000, misleadingly suggesting a more robust business performance.



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In contrast, the accrual basis accounting method provides a more accurate representation of your financial standing. It aligns expenses with their respective periods, even when cash transactions remain pending. This paints a clearer picture of your genuine profitability and financial commitments.

Suppose you're unlikely to incur monthly expenses of $10,000 or more. Instead you lead a modest service-oriented business, perhaps specializing in cleaning services. (though when if you purchase a large wearable vacuum cleaning in December to avoid excess taxes, you just might!) Opting for cash basis accounting would mean recording transactions solely upon cash receipt, which could potentially lead to gaps in your record-keeping. Delaying transaction recording until cash is received might result in distorted profits for multiple months. Even a small-scale hairdresser might find the simplicity of cash basis accounting marred by oversights, particularly regarding sales of supplementary products.

The primary downfall of cash basis accounting lies in the possibility of money slipping through the cracks! Why risk it!

So, What's would you need to change if setting up or switching to accrual. You don't alter how you handle your current cash transactions; those continue to be recorded upon transaction. Instead, when making sales or purchases on credit, you log them when the transaction occurs and not when the cash changes hands. Just as you wouldn't postpone recording personal credit card transactions until payment (at least you shouldn't!), you shouldn't delay recording business transactions. Your awareness of pending obligations remains intact. Your personal financial strategy likely involves tracking owed and due money – much like a monthly budget. This mirrors the concept of a business budget, where assets or liabilities are recorded as they arise, allowing for more effective financial planning.


In addition, generally Accepted Accounting Principles (GAAP) necessitates the use of the accrual basis of accounting. GAAP is a set of accounting standards and guidelines that are widely accepted and followed in the United States. These principles provide a framework for how financial statements should be prepared and presented to ensure consistency, comparability, and transparency across different businesses and industries. We will delve more into them in another post. However, following these standards is essential to getting a business loan!

In summary, the limitations of cash basis accounting arise from its inability to provide a comprehensive and accurate depiction of a business's financial performance, particularly when temporal disparities exist between transaction recording and cash exchange. The accrual basis accounting method is widely acknowledged as a more precise tool for faithfully reflecting a company's financial reality.


Warmly,

Caila Carreno

Founder, Polish and Precision


Disclaimer: The information provided in this blog is for informational purposes only and should not be considered as professional advice. Always consult a qualified accountant or financial expert before making any decisions based on the content presented here.

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