Cash vs. Accrual basis — what is the difference?

You’re setting up your QuickBooks file for your new business and it’s asking you…cash basis or accrual basis?

Or, you are modifying a report and you see a choice for cash or accrual.  You click “accrual” and all your numbers just radically changed.  What happened?  What does it mean?

I’ll try to explain the difference without going into too much accounting lingo.  Let’s suppose that your cupcake business has four separate events. 

1. You make a cupcake sale and send out an invoice to your customer
2. You collect the money from the sale and deposit it in the bank
3. You receive a bill for your electricity
4. You pay the bill

Cash basis will treat these events differently than accrual basis.  Let’s start with cash basis.

Cash Basis

In cash basis, the transaction is recorded when the money actually changes hands.  It doesn’t matter if it is a credit card payment, check, or actual cash.  So, for the events above…

1. You make a cupcake sale and send out an invoice to your customer — QuickBooks does not record anything
2. You collect money from the sale and deposit it in the bank — Quickbooks will now record the revenue as “Cupcake sales revenue” and it will increase your bank account by the amount of the sale.
3. You receive a bill for your electricity — QuickBooks does not record anything
4. You pay the bill — QuickBooks will record the amount as “Utility Expense” and it will decrease your bank account by the amount of the check.

Accrual Basis

Under the accrual basis, QuickBooks will record the event when the services occur, regardless of when the money actually changes hands.  Let’s look at the same four transactions under the accrual basis…

1. You make a cupcake sale and send out an invoice — QuickBooks will record the sale as “Cupcake Sales Revenue” and include the amount in your Accounts Receivable account.  (Your Accounts Receivable account is just a name of an account where amounts that you are due but haven’t received yet are put.)
2. You collect money from the sale and deposit it in the bank — QuickBooks will move the amount of the sale from Accounts Receivable into your bank account. QuickBooks won’t record the revenue now because the sale was already recorded when you made the sale in step 1.
3. You receive a bill for your electricity — QuickBooks will record the expense as “Utilities Expense” and include the amount in your “Accounts Payable” account. (Your Accounts Payable account is just the name of an account where amounts that you owe but haven’t paid yet are put).
4. You pay the bill — QuickBooks will move the amount of the bill from Accounts Payable to your bank account, which will decrease the amount in your bank account by the amount of the bill.  QuickBooks won’t record the expense now, because it already did so in step 3.

If you look at your business income and expenses over the whole life of the business, the total amounts recorded with cash and accrual basis are the same.  It’s just the timing that’s different. 

Which should I use?

So, now that you (hopefully) understand the main differences between cash and accrual, you are probably wondering which you should use.  Unfortunately, the answer isn’t completely cut and dry.  Although you may look in an accounting textbook and you’d think that the world would end if you decided to use the cash basis, the reality is that many small businesses use the cash basis in their books.

The IRS of course adds their $0.02 with a few rules and regulations about who can and cannot use cash and accrual.  And then, states like to step in too with various rules for sales tax reporting.

It really is worth it to get some professional help with setting up your business correctly with QuickBooks (or whatever software you use).  Doing it right from the beginning will get you going on solid footing.

Please feel free to give our firm a call at 770-478-7424 (whether or not you are in Georgia), or leave a comment, or send me an e-mail: kim@logginscpa.com.  We can help you choose which method would be the best for your business.