Being a small business owner, having an accurate account of your expenses is crucial for your growth and stability. But accounting is not a fun process, especially if you are bad with numbers.
The good news here is that there are only two methods that you need to deploy to keep a check on your accounts: cash-based accounting and accrual-based accounting. Even if you are not in charge of the accounting operations, you must understand the basics of these two bookkeeping practices.
In today’s article, we will discuss the major differences between cash-based and accrual-based accounting and what is best for your small business.
Accrual Vs Cash-Based Accounting
While accounting may be a boring subject, it is vital to understand how it works. Like everything else in your business, the owner should know something about everything.
According to the CRA business income is to be reported only via the accrual method. Blue-collar job holders like farmers, fishermen, laborers, and commission agents can use the cash method or the accrual method to report income, but not a combination of both.
Cash-Based Accounting
Cash-based accounting is a simple method. You record income as it is received and expenses as they are paid. For example, if you charge your client $5,000 on January 1 and receive the payment on February 15, you would record this income as received in the month of February. The rule here is, that money is recorded when it is in your hand.
The cash-basis method does not take into account any accounts receivable or payable. This is because it applies to payments from clients. It does not matter if your client has paid in cash, cheques, or via credit card, whenever the payment is received, it is recorded for that particular date.
Similarly, cash accounting will record an expense when money has been debited from your account. This can be the payment to your suppliers, vendors, or third parties that are selling goods or services to your business. For example, if you bought food supplies from a vendor in September on credit, and paid in October, then you would record those supplies as an October expense.
As mentioned in the previous section, the CRA allows business income to be reported in the accrual method. Blue-collar job holders can use the cash method, or the accrual method to report the income but not a combination of both.
Pros and Cons of Cash-Based Accounting
The cash-based accounting method has numerous benefits. It is a simple process that is ideal for small businesses. Moreover, it is quite cheaper than other methods and there is less information to track. While the system is quite easy to maintain on this method, there are some drawbacks to it as well.
Such as the restrictions that are applied to certain businesses that can use this method. Furthermore, once a small business starts to grow, it cannot use this method because of certain governmental policies. Lastly, these businesses cannot track long-term financial items and have fewer accounts at their disposal.
Here are a few pros and cons of cash-basis accounting:
Pros
Easy to record transactions
Since cash basis accounting is the simplest accounting system, it is relatively simpler for businessmen to understand, execute, and manage.
No need to record unpaid income and expenses
Contrary to the Accrual basis of accounting, there is no need to keep records of the unearned revenue or the expenses that have been incurred but not yet paid for.
Easy to reconcile
The adaptability of the cash-basis method is quite evident. It is easy to manage and cash flow can be viewed anytime rather than having to examine accounts receivable and payable.
Cons
Does not accurately match revenue and expenses making it hard to measure true profit
The matching principle is an accounting principle that requires businesses to recognize expenses at the very same time as the revenues to which they are linked. On a cash basis, revenue is recognized when money is received, which makes it difficult to assess profit.
Hard to keep track of liabilities which could result in poor planning and cash shortage
The obligations of your company are not shown on a cash basis. As a consequence, people may mistakenly believe that they have more money than they really do.
Isn’t the preferred method of accounting for growing businesses
Cash-basis accounting is not suitable for many organizations. You can’t utilize cash-basis accounting if to record your income, you require inventory., have more gross receipts than the IRS requires or you offer credit for services or goods.
Accrual Accounting
Accounting standards that are outlined by the GAAP (Generally Accepted Accounting Principles) make the use of accrual accounting for financial reporting.
This method provides a clearer picture of a company’s finances. With this method, income is recorded when billed and expenses are recorded when incurred. Contrary to the cash-based method, accrual accounting isn’t as concerned with when the money is actually received or spent. For example, if a business bills income of $5000 in the month of July, it would be recorded in the month of July, even if the money is received in August.
Similarly, if a food supply is bought on credit in the month of June, then it would be recorded in the expenses of June, even if the bill is paid in July.
Pros and Cons of Accrual Accounting
In cash accounting, there is a clear short vision of a company’s finances, but accrual accounting methods allow you to see in the long-term.
Accrual accounting accurately shows the money that is spent within a short time frame and provides a clear vision of when business speeds up and slows down. Moreover, this practice is totally in line with the national accounting standards, so if tomorrow, your business goes big, it will not have to shift its accounting method.
One of the biggest benefits of the accrual accounting method is that it allows you to anticipate future income and expenses. Additionally, you can project long-term profitability and make smarter financial plans.
However, there are some drawbacks to the accrual method. The first one is that it is more complex than other accounting methods: you will need more accounting knowledge to run this process.
In addition to that, the accrual method provides an inaccurate short-term view, which is not good for small business owners. Your books might be showing you a good view, but in reality, your bank account can be empty.
Balance Sheet
The balance sheet for accrual accounting includes more details and additional accounts. These accounts will include cash, equity, accounts payable and receivable, fixed assets, current assets, and long-term liabilities.
| Cash | Accrual |
| ✅Tracks cash, expenses, and income | ✅Uses advanced accounts such as accounts payable and receivable. |
| ✅Does not track long-term liabilities, loans, or inventory | ✅Tracks long-term liabilities, loans, and inventory. |
| ✅Record expenses when you pay and income when you receive them. | ✅Records income and transactions when you receive the bill |
| ✅Only for small businesses | ✅Large businesses are perfect for accrual basis, as stated by the CRA |
What Is The Right Option For Your Business?
For most circumstances, the Canada Revenue Agency (CRA) encourages business owners to use the accrual method of accounting to record both income and expenditure. Farmers, fishermen, and commission sales agents, on the other hand, can select between the cash and accrual accounting methods.
How To Shift From Cash Basis To Accrual?
Shifting from one acceptable technique to another, or from an impermissible technique to a permissible technique, is an accounting method change. A change in an entity’s accounting method is a shift in the entity’s general plan of accounting for gross revenue or expenses (accrual or cash systems), or an alteration in how an item is treated.
When it comes to a product, it’s important to know when to include that in the income and whether or not you can eliminate it.
There are two possible scenarios in this case. One involves switching from a cash basis of accounting to an accrual basis of accounting, while the other involves shifting from the accrual basis of accounting to the cash basis of accounting.
If someone wishes to switch from the accrual to the cash method of recognizing income, they should use the cash method when filing their next income tax return. It is important to ensure that they include a statement that details each change to the revenue and expenses as a result of the procedure differences.
Contrary to the above-mentioned approach, if someone wants to switch from cash to the accrual basis of accounting, they must first obtain authorization from the tax services office. One must request this change in writing before the due date for filing the income tax return, and then they must explain why they would want to switch the accounting procedures in the letter.
How To Select An Accounting Method
Your business needs will be different from others, so it is important to pick a method that suits your business requirements. Before choosing a method, weigh in these factors:
- The size of your business
- The growth projections of your business
- Accounting laws that have been made applicable by your provincial and regional accounting bodies
- Type of transactions you want to record
- The type of accounts that you need
- Your future accounting needs
Conclusion
Whatever method you choose for your business is going to be a management decision, based upon the goals you have set out for your business, the resources that are available to you, and the financial requirements of your business.
Some businesses can go for cash-based accounting, some can go for accrual. If you are growing as a small business, you can use the cash basis of accounting to report your income and expenses. However, as the CRA recommends, the accrual method is what you should opt for.
If you are unsure and confused about your financial process, make sure to check out and set up a consultation for your small business. We can solve all your financial tasks, accounting, and bookkeeping services in no time.
That is all for today, if you enjoyed reading this article, you can contact us at [insert mail]. Until the next one!
References
- The Accrual Method of Accounting | 2021 TurboTax® Canada Tips. (2021, March 29). TurboTax® Canada. Retrieved January 21, 2022, from https://turbotax.intuit.ca/tips/the-accrual-method-of-accounting-6192
- Berry, J. (n.d.). Modified Cash Basis Definition. Investopedia. Retrieved January 21, 2022, from https://www.investopedia.com/terms/m/modified-cash-basis.asp
- Small, Medium-sized and Large Businesses in the Canadian Economy: Measuring Their Contribution to Gross Domestic Product in 2005. (2015). Statistics Canada. https://www150.statcan.gc.ca/n1/pub/11f0027m/2011069/part-partie1-eng.htm
- Small, Medium-sized and Large Businesses in the Canadian Economy: Measuring Their Contribution to Gross Domestic Product in 2005: Main article. (2015, November 27). Statistique Canada. Retrieved February 1, 2022, from https://www150.statcan.gc.ca/n1/pub/11f0027m/2011069/part-partie1-eng.htm
- What is the definition of a small business in Canada? (201, September 29). Benchmark Law Corporation. https://www.benchmarklaw.ca/2019/09/28/definition-of-a-small-business-in-canada/
