Cash basis accounting is what most of my clients were using before I came along. This can work for some businesses, but most need to be using accrual.
What is the difference in cash and accrual basis accounting?
Accrual basis accounting:
- Shows revenue in the period that it was earned, whether the service/product has been paid for or not. This will show in your accounts receivable section of the Income Statement.
- Shows expenses in the period that they occurred whether you paid for it or not. This will show in your accounts payable section of the Income Statement.
Cash Basis Accounting:
- Revenue is recorded when you receive the payment.
- Expenses show in the period that it was paid for.
Why does this matter? Under accrual basis you are seeing a true snapshot of what money you earned and what expenses you incurred in that month. This is important when you are projecting sales and expenses and when you’re comparing different months.
Let’s look at an example. Say you sell a product for $1000 on May 25, but do not receive payment until June 10. If you use the cash basis, it will look as though you made that sale in June instead of May. Now look forward to next May when you’re forecasting revenue and expenses for June. Using your income statement, you will assume that you made $1000 more in sales than what you actually did. Not only were your May sales figures off, but now your June figures are off.
Now, $1000 doesn’t seem like a huge deal but when you do this with multiple sales, it’s going to make a large difference.
This is easy to fix. Go into your accounting software settings ( I use Quickbooks Online) and change the accounting basis from cash to accrual. Now, be sure to post transactions when the activity happens and ask your bookkeeper what accounting practice they are using.