Switching from cash-basis to accrual accounting is inevitable in the growth cycle of any business. Transitioning over to an accrual basis takes significant time and effort, but incorporating accounts receivable and accounts payable into your finances allows your organization to make smarter decisions.
Accrual accounting is a must when your business’ finances involve a lot of deferred payments from your clients and factoring in various debts and accrued liabilities. This method also ultimately provides you with a more robust cash flow projection.
Here’s everything you need to know about cash vs. accrual basis in a nutshell.
Cash-Basis vs. Accrual Accounting
Cash-basis accounting is a single-entry method of bookkeeping. Transactions are only recorded when the money enters or leaves your business’ bank account. It provides a simple view of how much liquid cash you have on hand at any given time but does not factor in pending debits or credits.
Accrual accounting is a double-entry method of accounting where the number of debits must equal the number of credits. This approach ensures that the basic accounting equation of net income (assets = liabilities + equity) is always in balance. This system allows you to factor in the impact of business loans and other debts, while also factoring in impending cash flow to your business from clients or investors. The other significant difference is that you will be paying taxes on money still owed.
Your credits and debts will be reflected in your various financial statements (balance sheets, income statements, cash flow statement, budgets, etc.), and your accounting checklist should include, at a minimum, the following:
- Accounts Receivable
- Accounts Payable
- Prepaid Expenses
- Fixed Assets
- Accrued Employee Vacation
- Accrued PayrollPPP Loan and PPP Loan Interest
- PPP Loan Forgiveness
How Does Accrual Accounting Affect My Cash Flow?
Say you send out a client invoice for $2000, due next month, and the client paid a $500 deposit to you this month.
Under cash-basis accounting, your income for the month would only be $500, as the remaining $1500 is still pending.
With accrual accounting, you are declaring the full $2000 as income (both the liquid $500 and the impending $1500) in that accounting period. Similarly, you’ll be factoring in money you owe ahead of time as a debit. This allows you to make smarter financial projections and increases the overall size of your cash flow.
However, it also requires you to keep a steady eye on how liquid you are at any given time, your working capital, so you’re not overextended on liability at any point. Cash flow statements and projections factor in all cash, income, and expenses in analyzing financing, investment, and operations.
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How Does Accrual Accounting Affect Taxes?
Under accrual accounting, you will need to declare any income from invoices sent within a fiscal year, even if the client does not pay the invoice until the following year. This requirement can allow you to strategically send or defer invoices towards the end of the reporting year when it is advantageous to do so. Some exceptions do exist as businesses with revenue under $5MM in revenue can complete their tax returns on a cash basis (a topic for another blog post).
What is Involved in Switching From Cash-Basis to Accrual Accounting?
Switching to accrual accounting requires you to completely overhaul your existing bookkeeping and accounting solution, as well as your reporting tools and templates. All your journal entries need to be adjusted to incorporate both accruals and deferrals, and you also need IRS approval to change from cash-basis accounting to accrual, which requires you to file IRS Form 3115.
This entire process requires both thought and planning. If you’re still utilizing spreadsheets to record finances or using a solution such as Bench or Pilot and considering making a switch, this process may seem daunting.
Here at Greenough Group, we have over 20 years and 800 companies worth of expertise. If you’d like to receive a free consultation on how our accounting specialists can assist your growing business overhaul your financial processes and reporting to set yourself up for success, drop us a line.