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Cash vs. Accrual Accounting: Understanding the Distinctions

As a small business owner, you can choose between two accounting methods for setting up and managing your bookkeeping: cash accounting and accrual accounting.

 

There is a significant difference between cash-basis and accrual-basis accounting in terms of recording revenue and expenses. Accrual accounting records revenue and expenses when transactions occur, regardless of when payment is made. In contrast, cash-basis accounting records revenue and expenses only when payments are actually received or disbursed.


Cash vs. Accrual Accounting

Selecting the appropriate accounting method will help you fulfill your reporting obligations and effectively manage your company's financial health.

 

Understanding the Differences Between Cash and Accrual Accounting

 

The primary distinction between cash and accrual accounting lies in the timing of revenue and expense recognition. This guide provides a detailed explanation of revenue recognition. The fundamental differences between cash and accrual accounting are as follows:

 

  • Cash accounting recognizes revenues and expenses at the time when money is exchanged.

  • Accrual accounting recognizes revenues and expenses at the time the transaction occurs.


Cash Accounting             

Accrual Accounting

Recognize revenue when cash is received

Recognize revenue when it is earned (i.e., upon job completion)

Recognize expenses upon expenditure of cash

Log expenses upon incurrence

Taxed on income only upon receipt of cash          

Taxed on income regardless of whether cash has been received

Applicable exclusively to farmers, fishers, or self-employed commission agents in Canada

Mandatory for businesses in Canada to report their income to the Canada Revenue Agency

Cash-Based Accounting

Cash accounting records revenue when payment for a sale is received and expenses (including prepaid expenses) when payment is made for a purchase. Determining the timing of a transaction is straightforward—simply check when the money entered or exited your bank account.

 

Many business owners favor cash accounting because it eliminates the need to track accounts receivable and accounts payable.

 

While cash accounting offers an accurate snapshot of your current cash flow, it doesn't accurately represent your long-term financial health. This can result in understated expenses or overstated income.

 

Consider this example:

Mark had a slow sales month in January, completing only two landscaping jobs. However, that same month, he received $6,000 in overdue payments for work done in November. With cash-basis accounting, John's records would indicate strong performance in January, even though his business actually struggled.

 

Accrual-Based Accounting

Accrual accounting records revenue when a service or product is delivered and expenses when they are incurred. It is more complex than cash accounting because it requires tracking invoices in addition to monitoring your bank accounts.

 

Accrual accounting provides a realistic view of your business's financial health by better aligning the timing of revenues and expenses. Consequently, it can help you:

 

  • Clearly view upcoming expenses as well as income and expenses from past periods.

  • Identify income trends and customer spending habits.

  • Develop cash flow forecasts to better manage working capital during slow periods and resources during peak periods.

 

It’s important to note that lenders and investors usually prefer financial statements prepared using accrual accounting.

 

Recording Transactions in Cash vs. Accrual Accounting

 

Revenues and expenses are recorded differently in cash versus accrual accounting. Here are a few brief examples:

 

Recording Revenues

Mark completed a landscaping job on October 21, 2019, and received payment on January 10, 2020:

 

  • With cash accounting, Mark would record the revenue on January 10, 2020, when he received the payment.

  • With accrual accounting, Mark would record the revenue on October 21, 2019, when he performed the job.

 

Recording Expenses

Mark bought 10 bags of soil on December 10, 2019, and paid his supplier on January 8, 2020:

 

  • With cash accounting, John would record the expense on January 8, 2020, the day he paid his supplier.

  • With accrual accounting, John would record the expense on December 10, 2019, the day he purchased the fertilizer.

 

Tax Implications to Consider

 

Income taxes are also handled differently in cash and accrual accounting:

 

  • In cash accounting, your business income is taxed when the money is deposited into your bank account.

  • In accrual accounting, your business income can be taxed even before you receive it.

 

For instance, if you send out invoices at the end of the year and they aren't paid until the new year, accrual accounting requires you to record the revenue when the sales occur. Therefore, you must include that income in your year-end tax reporting.

 

Consider the following example:

Mark completed a landscaping job on October 21, 2019, and received payment on January 10, 2020:

 

  • With cash accounting, Mark would record the revenue on January 10, 2020, the day he received the payment, and report it as 2020 income.

  • With accrual accounting, Mark would record the revenue on October 21, 2019, the day he performed the job, report it as 2019 income, and pay taxes accordingly.

On the plus side, with accrual accounting, expenses are recognized when incurred. This means if you receive an invoice late in the year but don't pay the bill until the new year, you can still deduct that expense when reporting your year-end income.

 

Selecting the Appropriate Accounting Method

 

Most small businesses in Canada must use accrual accounting to report their income to the Canada Revenue Agency (CRA) and prepare their financial statements in accordance with ASPE (Accounting Standards for Private Enterprises).

 

However, if you’re a farmer, fisher, or self-employed commission agent, you can choose either cash or accrual accounting, provided you:

 

  • Use accrual accounting for any separate business activities.

  • Use accrual accounting for GST/HST/QST purposes.

  • Maintain separate bookkeeping records for each accounting method you use.

 

It's best to consult your accountant before deciding on an accounting method. Meanwhile, keeping your books up to date will help you avoid last-minute stress during tax season.

 

If you're unsure how to organize and maintain your books, Bluemount Backoffice Solutions's experienced team of accountants and bookkeepers can assist you. Contact us today for more information.

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