LGA Partners Janine Danielson and Frank Storniolo are discussing cash based accounting and accrual. Do you know the difference, and why you might choose one over the other? Both approaches have advantages, but being strategic in the accounting method you choose can help you in other areas of your business management. If you’re confused or overwhelmed by setting up your accounting procedures, the professionals at LGA are here to help. The Outsourced Management Accounting team can assist with a wide range of accounting questions and services.
[Janine]: Hello, my name is Janine Danielson and I lead the outsource management accounting services here at LGA.
[Frank]: Hi, my name is Frank Storniolo and I lead the consulting and business valuation services here at LGA.
[Janine]: And what we’d like to discuss today is how best to record as a business owner, your accounting transactions. Frank, can you give us the options of how to record your accounting transactions?
[Frank]: Sure. Uh, there are two main options in recording accounting transactions. The first is cash basis, which literally records revenue when cash is received, uh, and expenses when cash is paid. The other is the accrual basis, which recognizes revenue when revenue is earned and expenses when they are incurred. So needless to say, the accrual basis does not necessarily follow cash flow of the business.
[Janine]: Okay. So the options as a business owner, can we go through a couple of examples of cash versus accrual? First one, customer deposits. So let’s say that a business owner gets $100,000 in, for example, for a project that is not going to start for a couple of months. Cash versus accrual.
[Frank]: Sure. Under the cash basis. Uh, the a hundred thousand dollars payment would be recorded as revenue. Uh, you received the cash and therefore that’s recorded even though no work has been done. Under the accrual basis, that revenue would be deferred until work is commenced and so that would be the difference under the two scenarios.
[Janine]: Okay. Another example insurance policy. It’s a term of 12 months, so if I pay my insurance all at once, but the term is 12 months, how is that recorded? Cash versus accrual impact?
[Frank]: Sure. When the insurance policy is paid under the cash basis, that would be recorded all in the month that was paid and therefore it would, it would give you somewhat of a false sense of profitability in the month that was paid. Under the accrual method that insurance policy would be, that expense would be spread out over the over the next year or the length of the insurance policy coverage and therefore better matching the expense with with income of the business.
[Janine]: Okay. Budgets. Do budgets impact at all cash versus accrual?
[Frank]: Absolutely. For budgeting for a business, it’s, it’s much more difficult to predict a cash basis type budget where you would be predicting when cash would be coming in and therefore when expenses could be paid. We suggest in a best practice would be to create budgets under the accrual basis, which would be when that revenue was earned. It’s a better way to predict and when expenses are incurred. But if you’re a startup or a small midsize business, um, who’s looking at a number of scenarios, uh, such as, uh, the possibility of obtaining back financing in the future or achieving growth where a financial statement and audited financial statement may be necessary or, or the uh, ability to produce a budget to actual, uh, type reports for the business and, and track company metrics or what they call KPIs. Our suggestion would be to, to produce those accounting records on an accrual basis.
[Janine]: Okay. Now the question, if I started my business, I’m on the cash basis now, am I stuck or can I convert change to accrual? If that is what I would like to do.
[Frank]: Sure. Yeah. There, there is the ability a, you are not stuck. So there is the ability for a business to convert from the cash basis to the accrual basis with some accounting guidance and accounting assistance.
[Janine]: Okay. So I think what we’ve learned today is cash seems to be the easiest to report and record. But as Frank with the examples we just described with customer deposits and expenses might not ha show the true profitability of a company and net income under cash basis would be different than under the accrual basis. And depending on your management decisions during the year, it may impact that. So we urge you to contact myself or [Frank]: to continue this conversation of cash versus accrual. If there’s any questions you have in the future.