Peter G. Robbins, The Daily Record Newswire
Q: I opened my small law practice in Twin Falls recently and spent some time getting my accounting system set up. I am using QuickBooks, but I noticed that when I print reports I can select either “cash” or “accrual.” Which is better?
A: The designation of cash versus accrual refers to the overall method of accounting that the software will use in generating reports, but it is really more encompassing than that.
The overall method of accounting really determines how and when you will record transactions in your accounting system. When I was teaching college-level accounting courses, I found that the concept of cash versus accrual required quite a bit of explanation, and in the real world of accounting this seems to be a topic that confuses many business owners.
Generally, the cash method of accounting is the same as how we track our own personal finances; think of it as the method you use to track your checkbook. As cash is received, it is recorded as an increase to your checking account or income, and as cash is spent, it is recorded as an expense. If at the end of the month or year you have spent more than you received, you have a loss, but if your receipts exceed your expenditures, you have income. For many small business owners, this cash method is what matters, since “cash is king.”
But for a business, the cash method usually does not truly reflect the performance of the company. Under a true accrual method of accounting, revenues are recognized when the sale is made or the services are preformed. This is a bit of an oversimplification, and generally accepted accounting principles provide for a host of rules on when revenue is recognized. So for example, if you provide legal services in January but your client does not pay you until February, there will be a difference in when the revenue is booked. Under the cash method it will be recorded in February, when the payment is received, but under the accrual method it will be booked in January, when the services were performed and billing occurred.
Further, under an accrual method of accounting, expenses are recognized when incurred rather than when paid. Sometimes expenses are incurred and paid at the same time, but usually the timing differs. For example, the electric bill you receive and pay in February was probably for power you used in January. Under a cash method the expense is recorded in February, when paid, but under an accrual method the expense is recorded in January, when the electricity was used.
Keeping a quality set of accrual basis books is the way to go from a management perspective, but having access to cash basis reports or a cash flow statement is equally important. The accrual books tell you how your business is doing regardless of the cash flow. The accrual books tell you how much you earned from your sales or services versus how much cost you incurred in a given period of time. In essence, an accrual-basis income statement tells you how much net income you truly made during the month, quarter or year, and an accrual balance sheet tells you what you have, including how much customers owe you versus what you owe to others. Of course, you still need to monitor your cash situation. That can be done via your cash-basis statements or by learning to use a cash flow Statement. Also, for tax filing, you will want to use cash-basis statements. Generally, the cash method minimizes your taxable income, as receivables for services are ignored until collection occurs.
By monitoring your accrual-basis accounting statements, you will be better able to judge if your business is making money or losing money, and what you need to do to be more successful. You will also be able to judge any short-term and long-term cash needs. So I highly recommend that you keep your books on an accrual basis, or at least on as much of an accrual basis as is practical. This may require some education or professional assistance to understand how an accrual system works and how to interpret the statements, but you will find these statements highly beneficial to managing your business.
And speaking of understanding financial statements, check back in two weeks for a follow-up question.
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To ensure compliance imposed by IRS Circular 230, any U.S. federal tax advice contained in this article is not intended or written to be used, and cannot be used by any taxpayer, for the purpose of avoiding penalties that may be imposed by governmental tax authorities. The answers in this column are meant to offer general information. You should consult your tax adviser regarding the specifics of your situation.
Peter Robbins is a partner in the Boise office of CliftonLarsonAllen LLP, specializing in tax matters for small businesses, individuals, and trusts and estates.
