Cash vs Accrual Accounting
The difference between cash and accrual accounting relies on when the revenues and expenses are recorded in your accounts. Cash accounting recognizes revenue and expenses only when money changes hands, but accrual accounting recognizes revenue when it’s earned, and expenses when they’re billed (but not paid).
Accrual Based Accounting
With the accrual method, revenue and expenses are recorded as they occur, regardless of whether or not cash has actually changed hands. An excellent example is a sale on credit. The sale is entered into the books when the invoice is generated rather than when the cash is collected. Likewise, an expense occurs when materials are ordered or when a workday has been logged in by an employee, not when the check is actually written. The downside of this method is that you pay income taxes on revenue before you've actually received it.
The accrual method is required if your business's annual sales exceed $5 million and your business is structured as a corporation. It's also highly recommended for any business that sells on credit, as it more accurately matches income and expenses during a given time period.
Using the accrual method provides one major advantage and one major disadvantage to your business. The disadvantage comes from the timeliness of booking revenue and expenses and how that can cause cash flow issues on a day to day basis. The advantage is you can match your revenue and your expenses to when they actually occurred in your business, you can get a clear picture of the profitability of your business on a month-to-month basis. This advantage also allows for much more clear long term vision into your business to make financial decisions.
Cash Based Accounting
Cash accounting is best when tracking the actual amount of cash the company has at any given time by tracking revenue and expenses as they are paid or received. Your business's cash flow is your leading indicator for your cash on hand to show if you are profitable or not. The loophole in the cash method is that your income statement, revenues, and expenses do not give you a clear picture of your financial activity for a specified period.
Another thing to consider is that this accounting method is not accepted under the Generally Accepted Accounting Principles as one of the ruling standards in accounting.
However, the cash method may also continue to be appropriate for a small, cash-based business or a small service company. Another benefit to a small business is that you are only expected to pay taxes when you receive the revenue instead of when it was agreed too. The disadvantage is that it does not provide you with a record of accounts payable and receivables. Without a record of what you’re owed and what you owe, you don’t have the complete picture of your financial status.
For example, if you have yet to pay your bills for the month, cash basis accounting could lead you to believe that you have more money than you actually do.
We recommend that sellers meet with an accountant to decide prior to listing your business which way is best for you to clearly represent your business to buyers. Based on the industry or how you bill customers may determine the best strategy for you and your business to get a correct valuation.