Accrual vs Cash-Based Accounting

A very important subject.  Is your accounting and taxes done in the Accrual method or in the cash method?  This episode discusses the differences between them and how it affects bookkeeping entry. 

Transcript

                                       Accrual VS CASH Based Accounting 

There are two main methods on bookkeeping and tax accounting according to GAAP AKA (Generally Accepted Accounting Principles) – and I promise!  I’ll try and follow the ‘Not Boring’ part of the name of this Podcast series!

1.  CASH based 

2.  ACCRUAL based  

Cash based bookkeeping and accounting is generally easier for the bookkeeper and the tax preparer because it’s rather literal. That is -- money that is received by selling a service or a product in a given calendar year is taxable income, and money that is paid by a company is a tax deduction as long as it’s deemed a ‘business expense’.  The literal exception is that when you use a credit card for purchasing something for the business, the IRS considers that a cash transaction, because the credit card company (the bank) pays the store or vendor on your behalf usually within 24 hours or sooner. By the time you get the credit card statement, you are basically reimbursing the credit card company for money that they have already laid out on your behalf.  Checks, Zelle, Venmo, Paypal, credit cards, Wire transfers – basically any way that you pay an expense for your company is considered cash. Think of cash- based bookkeeping and accounting as paying for goods and services as you purchase them. You receive the goods, and you pay for them. You receive the services and you pay for them—all at the same time. Like I mentioned --- Literal. 

For one example, If I were to go to a company’s offices, and do bookkeeping for the day, but before I leave, I am a handed a check, or a Zelle payment or a Venmo payment, then, when I get back to my office, I will email a Sales Receipt to my client, not a customer invoice. 

If I left the clients’ offices and didn’t get paid, then when I got back to my office, I would Invoice my client so that I could get paid later. More about that in a few minutes. 

So, CASH based is counting money received as taxable income and counting money spent as a tax deduction for the business. Basically think of it as: Money in/Money out. 

Accrual Based Accounting: 

If your company sells goods and services and THEN bills (or invoices) its clients or customers to pay later, then we  consider that Accrual based. If you sell goods or provide a service today, invoice the customer and get paid tomorrow or next week or next month, that’s Accrual bookkeeping. The IRS says that in an Accrual basis, the income is earned immediately after you provide services or sell products (with some exceptions that we’ll talk about later) even before you get paid. Therefore, even if you don’t get paid by the end of that calendar year, that unpaid customer invoice is still considered earned revenue – in other words -- taxable income. If the customer defaults and never pays you, then your company can ‘write it off’ and the ‘write off’ transaction becomes a tax- deductible expense. So, no harm done, just more work to get there. 

On the other hand, if you have a utility bill come in on December 27th, and you pay it in Jan. of the next year, in accrual accounting, that expense is tax deductible in the preceding year, even though you haven’t paid it until the subsequent year.

Generally, service-based companies are in a CASH basis, and manufacturing and restaurants, for some examples are in the Accrual basis. But exceptions to this unwritten rule can and do happen on a regular basis.  

Now – I’m going to put a little bit of a monkey wrench in to this equation by talking about shipping products. If you ship items from a store or a website on December 15th, and the goods don’t get to their destination by December 31st, and you can prove that, then in Accrual, the IRS says that since the items aren’t received at their destination yet, you haven’t actually ‘earned’ that money.  Therefore, even in Accrual accounting, the invoice that you have dated December, could be changed to reflect a date in Jan. in the next year. However, your bookkeeper or tax preparer can make an ‘Accrual Entry’ in the books to reflect that value of the invoice in December and move it to Jan income for the next year.  Therefore, since the shipment hasn’t reached it’s destination by December 31st, it’s not considered taxable income since you didn’t actually make the sale yet, even if the customer pre-pays you before you ship it out. Just because a customer pre-pays for something, it doesn’t necessarily mean that monies received is counted as taxable income.  If the shipment is lost and never gets to the recipient, and you can’t replace it because it was unique, for one example, then you would have to refund that money.  Therefore, in that case, the customer payment is technically a liability of your company until you can prove that it’s actually earned income that is income taxable. Sales taxes work in a similar way.  If you invoice a customer in December and the customer doesn’t pay until Jan., even if you are in a cash basis, most states want you to pay the sales tax even before your customer/client pays you.  If they never pay you, you can get a credit from your county or state sales tax agency. 

If your company is on an Accrual basis, and the company pays a November and December utility bill in Jan. of the next year, that figure can be ‘accrued’ back to the preceding year so that the company can get a tax deduction in the year that the expense actually was, just by either entering a bill in the preceding year and paying it in the new year, or making an accounting entry using accrual adjustment entry for the payment if the bill isn’t entered.

As I said earlier, a lot more work in Accrual accounting then cash-based accounting. However, it’s the most ‘fun’ that I have all year with all of this --- moving taxable income from one year to another knowing that it’s 100% ethical and legal and it follows the IRS and GAAP codes. 

If your taxes have been in a cash basis, you are allowed to change accounting methodology every 5 years or so, but it ‘could’ be a flag for the IRS and the possibility of an audit could tick up a notch.  So, as I always say, please have this conversation with your accountant or CPA or tax preparer to see what methodology is best for you and your company.  And also, make sure that your bookkeeper knows the difference between accrual and cash- based bookkeeping so your books will be in good order even if there is a change! 

And now, for our ‘client story of the week’ –  

I have been consulting with a client for the last 17 years after I initially set up the books for this company and have seen it grow to a multi -million corporation.  They have always been on accrual. They ship goods mainly out of the country, with some domestic sales and shipments.  In December of every year, there are always 20 to 30 invoices that are anywhere between $100,000.00 and $250,000.00 ---all for goods shipped out of the country and going through customs.  It was determined that it takes 35-37 days to get to its destination.  And for years, the client was very happy that the company had a great December.  The accountant and I used to joke with her by saying that she closed shop and was on vacation in December!  And she said, NO – I was here!   The point was that all of those invoices created in December were all in the shipping process. They were not yet received at its destination. Therefore, we would make entries so that the invoices showed up in the middle to late Jan.--- AFTER the items were received by the recipient. THEN they were considered taxable sales. The owner of the company never really understood that concept, but there it was… she was able to postpone paying taxes on those sales until they were ‘technically’ taxable revenue.  

There are lots of ways to do bookkeeping for accrual. The bookkeeper doesn’t necessarily have to enter every single bill and bill payment.  He or she can just enter all of the bills that were unpaid on December 31st of that current year, so that they would be counted as deductions. As the open bills were paid in Jan or Feb. the payments would be attached to the open bills so that those bills would show as paid. Or one adjusting accounting entry with many categories all attached to the Accounts Payable account on the Chart of Accounts.

The moral here?  Try to be on a cash basis --- it’s easier, less headaches, and less cost for your accounting and bookkeeping. There are, however, some pros on being on accrual since you can legally and ethically move income from one year to another and move expenses from one year to another.  If you are on an Accrual tax basis, and you pay a utility bill in Jan. for the December usage, the bookkeeper doesn’t have to enter an unpaid bill in the system, ---your tax preparer can make an entry moving the value of that Jan. payment into December since you are paying for utility usage for December.  

I don’t expect small business owners to be bookkeepers or accountants, but I think it’s important for business owners to at least understand the general concepts. It’s your business and you should have at least enough knowledge of the accounting to make informed decisions on how you want to run the business and account for the business within your tax structure. 

Many bookkeepers don’t know the difference between accrual and cash-based accounting, so make sure that when you hire someone, that should be a question for them during the interview to make sure that they understand the concept and if they if they have clients on an accrual basis as well as a cash basis. 

There are always many questions on this when I do webinars on this subject. So, as always, please email your questions and comments to : 

BookkeeperMensch@Gmail.com  or 

Numerex@numerexonline.com and I will answer them in upcoming Podcast episodes. 

Thanks for listening --- and until next time ----   I’m Paul Rosenblum