BASIS OF ACCOUNTING: HOW TO DECIDE WHETHER TO USE CASH OR ACCRUAL ACCOUNTING
James runs a side business selling paintings. He does not sell on credit often and he buys all the materials for making the paintings from his local store on cash. In keeping financial records for the business, what basis of accounting should James use?
By basis of accounting, we mean the time in which the various financial transactions of a business are recorded. Should they be recorded immediately value is exchanged or should they only be recorded on receipt of cash?
There are two ways businesses track expenses and revenues: cash accounting/basis and accrual accounting/basis. In the hypothetical case above, cash accounting would be the more straight forward way for James to do his accounting. However, big companies are frequently required by law to use accrual accounting. Firms, Households, Individuals and even countries use the different basis in various situations.
In cases where there is no restriction on which method to use, deciding whether to use the cash method or the accrual method is an important decision for every business as there are advantages and disadvantages mostly due to the tax and business implications.
The cash method is a straightforward method. Expenses are only recorded when they are paid and revenues are recorded only when the cash comes in. For example, a farmer selling oranges to a supermarket uses cash accounting. He gives the supermarket oranges on consignment and the supermarket pays him every weekend for sales made during that week. The farmer would only record as sales the amount that was paid to him every week and not the actual value of the oranges he gave to the supermarket.
There are implications to the use of cash accounting. For example, it may not give a true view of the profit made in a particular time period. It measures pure cash flow and thus sometimes gives a false impression of long term profitability. It is not suitable for companies that carry out a lot of business on credit.
Its major advantage lies in its simplicity. The business does not need to hire expert help as in accrual accounting. Under the cash method, any customer payments the business received in say, 2016 for projects completed in the previous year would be counted as revenue for the 2016 tax year. This reduces the taxable income and as a result, it can lower the tax payments for the 2015 tax year.
The accrual method is the more formal method and records expenses and revenues when they are incurred and earned respectively. The business invoices the amount in question and records it even though the payment has not actually been received. Expenses are thus matched with revenues. For example, a laundry business using accrual method receives quarterly utility bill for November, December and January. Under cash accounting, this expense would only be recorded when it is paid. Accrual accounting, on the other hand, would estimate two months’ portion of the expense (November and December) and record it in the previous year’s financial statements.
Expenses and revenues are thus recorded whether or not cash is made. This has the implication of given a true view of the profitability of the business under a particular time period. Accrual basis of accounting often require expert help as it is complicated. In the example above, adjustments might need to be made as the cleaning company would have estimated expenses before the utility presents the bill. Due to the costs, small companies may not implement accrual accounting.
In conclusion, the decision to choose between cash and accrual basis should not be taken lightly. For a small company with low growth, the cash accounting method may be cheaper. However, companies that intend to grow would eventually need to use the accrual basis.