As a business owner, it’s important to know about (almost) every part of the business. However, things like accounting should really be left to the accountants. A big reason for this is that there are different types of accounting that need to be used in different businesses.
That’s why in this blog we want to provide some insight into the differences between two common types of accounting seen in business – cash and accrual accounting.
In simplest terms, the difference between cash accounting and accrual accounting is when the sales or revenue, and the purchases or expenses, are recorded in your accounts/books. Your sales and purchases may also be referred to as transactions.
When looking at accrual accounting, it recognizes revenue when it is earned, but payment has not yet been received and it looks at expenses when they are billed out or incurred, but they are not yet paid.
Cash accounting on the other hand recognizes revenue and expense only when money actually changes hands- or goes into or out of your bank account.
What’s the difference and which one should you use?
Cash Accounting
Cash basis accounting means that you acknowledge the cash when it is actually received and you acknowledge your expenses when you actually pay them.
Some may prefer this method of accounting because it is simpler. With there not being any accounts receivable or accounts payable, you know when the transaction took place (either your sale or expense) and you can track your company’s cash flow by simply looking at your bank statement. It gives you a picture of your current finances.
Another benefit comes at tax time. The reason for this is that you are acknowledging transactions that have actually taken place and that reflect what is in your bank account at that time. This means that you aren’t paying tax on pending transactions, being transactions, or sales that you have yet to receive the cash for.
A downfall to cash accounting is that even though it shows how much money you have right now, it doesn’t show an accurate picture of your financial state over the long term. This means that it may overstate your income or understate your expenses. It could be showing you that your business is booming this month when in fact you are not busy at all, you are simply receiving payments from your previous months’ work.
Cash accounting does not take into consideration any accounts receivable or accounts payable.
Accounts receivable (AR) is the balance of any money due to your company for goods or services that you have delivered but have yet to be paid for. Accounts payable (AP) on the other hand is the money that you still owe to your suppliers or vendors and have yet to pay out.
Having no AR or AP accounts can create challenges for your company. If you don’t receive immediate payment for your services or if you have unpaid bills, you may not have an accurate method of tracking this money.
As an example of cash accounting, your company is a fishing company based out of Vancouver, BC. Things are going pretty well for you and you have just sent out an invoice to one of your customers for $10,000 for some seafood that you just sent out. As well, you have a customer that sent in their payment of $5,000 for some seafood that you shipped last month.
You have also just received an invoice for $2,500 for repairs on some equipment, and you’ve had to pay the invoice for fuel that you picked up last month for your operations, which was $1,000.
If you are using accounting, you would only look at the money (cash) that has actually exchanged hands. This would include the $5,000 coming into your bank account and $1,000 going out as your payment, so your accounts would show that you net $4,000 for this month.
Even though this may seem to be an easy way to do your bookkeeping, it is limited in Canada as to who can use this system at tax time. According to the Canada Revenue Agency, you can use the cash accounting method if you are:
- A farmer,
- Fisher,
- Self-employed business,
- Professionals (i.e., people offering professional services), or
- A commissioned salesperson (like a realtor) in Canada.
As well, even if you fall into one of these categories, you may only want to use cash accounting if you are a smaller business and don’t have much inventory.
Accrual Accounting
Accrual accounting is typically more common than cash accounting not only because it is required by the CRA in most circumstances, but because it gives you a more realistic and overall picture of how your company is doing financially.
Accrual accounting is where your money coming in, or revenue, is acknowledged at the time of when it is earned. It doesn’t matter if the money has actually been received yet or not. As for expenses, they are acknowledged when they occur, not when you pay them. For example, you are picking up supplies from a business that you have an account with. Accruals are done at the end of an accounting period, which is typically monthly.
This means that you would recognize the revenue when you have sent out the invoice, not when you actually receive the money. Likewise, you would recognize your expenses when you incur them, not when you pay them.
As with cash accounting, there are benefits and detriments that need to be understood.
A benefit of accrual accounting is that it gives you a clearer picture of income earned and expenses incurred during a period of time. For example, if you don’t get paid for 30 days past completion or delivery, you will still realize that money was earned during this period of time. This is beneficial when you are looking at and long-term planning and your company’s financial status.
Although accrual accounting is more work, it does provide that more realistic picture. Some business owners may find that accrual accounting is a bit complicated though because, in addition to keeping track of your accounts payable and accounts receivable, you also need to separately keep track of your cash flow.
You need to be aware of your cash flow so that you know where you are at today.
If you only look at what you have earned, you may see a very different picture than what your actual bank account reflects. When we talk about cash flow, we are talking about the actual amount of money being transferred in and out of your company, and how much is actually there. This is vital to track so that you know you have the money to be able to pay your bills on time.
To look at an example, let’s look at the fishing operation we discussed above. You have just sent out the invoice to your current customer for the $10,000 seafood shipment. As well, your other customer has sent in their payment of $5,000 from last month.
You had also just received an invoice from the maintenance company for $2,500 for the work they just completed, and you’ve had to pay $1,000 for the fuel that you picked up last month since that bill is now due.
If your company is using the accrual method of accounting, your profits have jumped to $7,500! We are only looking at the sale and invoice that occurred this month, we aren’t looking at sales or expenses from last month. $10,000 less $2,500= $7,500.
Again, this can show you a more accurate picture of your income and when it was actually earned, but you will need to keep an eye on your actual cash flow so that you know how much money is in your bank account right now.
Summary
No matter which method that you use, cash accounting or accrual accounting, it is important to understand that you cannot mix these two methods of accounting. For example, you cannot use cash accounting for your expenses and use accrual accounting for your revenue. You have to use the same type of bookkeeping with both your expenses and revenues.
You may choose for your company to use an accounting software program to keep track of all of your transactions, or you may decide to employ a bookkeeper (like Valley Business Centre) to record your transactions for you. Whether this is done on a monthly or annual basis, you will need to remember that all of your transactions need to be recorded for filing your taxes.
It is always best to check with your accounting professional, and they can recommend which type of accounting would work better for your company and what will be involved.
Need help from an expert?
As accounting and keeping track of your accounts payable, accounts receivable, and cash flow may be confusing, let one of our experts at Valley Business Centre help. For over 30 years, Valley Business Centre has been providing comprehensive bookkeeping, payroll, and tax services to our clients in Whistler, Squamish, the Sea to Sky Corridor, and metro Vancouver B.C. areas. Valley Business Centre provides reliable and effective services to all clients.
Disclaimer
This article is written for informational purposes only. It is current at the date of posting and changes to laws and regulations may result in the information becoming outdated. It is not intended to provide legal, tax, or financial advice. It is recommended that readers get advice from a tax professional before making any final decisions.
