Cash vs. Accrual basis and QuickBooks
Many people ask me what is the difference between Cash and Accrual Accounting.
You know those Pepsid commercials at the fast food restaurants where the girl asks “Do you want it to hurt now or later?”. Well that’s sort of what Cash vs. Accrual basis is like. Well not really, but allow me to explain. The basis of the accrual method is in an accounting principle known as Matching. This means that we want to recognize income and expenses in the same period in which they were earned / incurred, regardless of whether or not things have actually been paid. So if I have rent that I pay each month, even though I may pay it late one month, I still want to report the rent expense in the period for which I was charged. So instead of showing rent for double the amount in the following month (when it was all paid), I still show the expense for each month in it’s own month even though I actually paid 2 month’s worth of rent in the second month.
On the income side, I want to recognize the revenue when I’ve earned it, not when I get paid. The idea is that I reasonably expect to get paid, otherwise I would not go into business. So when I invoice a client, that is when I show the income under the accrual method. When I am analyzing my business financial information this makes more sense as well because I look at what it takes to run my business for a single month and I want to compare that with what I earned that month. So the accrual method helps us “normalize” the data.
As mentioned with the rent, under the accrual method, assuming rent is due on the first of every month, that is when I want to record it, regardless of whether or not it has been paid.
What does this look like in QuickBooks?
Under the accrual method, on the income side Income posts based on the invoice date. Or if there is no invoice and I record a deposit posting directly to an income account then the deposit date is the date on which the income is recognized for the simple reason that no accrual basis vehicle (like an invoice) was used to show the income in advance of receiving it. Similarly if I enter a sales receipt the idea is that I earned the revenue and got paid in one fell swoop, so of course the income date is in fact the same as the date I was paid. In QuickBooks the sales receipt’s date drives when/where it will appear on my profit and loss statement.
Under the accrual method on the expense side, an expense is recognized based on the date of a bill when I enter one. So if I post a bill on June 1, but don’t pay it until July 1, under the accrual method the expense is recognized on June 1.
So what about Cash basis? Cash basis says I don’t recognize income or expense until the money is actually received or paid. So in the example above under the cash method of accounting the expense would be recognized On July 1 because that’s when we actually paid the bill. On the income side, income would not be recognized until we receive a payment from a customer in QuickBooks and apply it to an invoice. Both conditions have to be met in order for income to show up on a cash basis P&L; 1 – Payment Received and 2 – applied to an invoice. If you simply receive a payment for a customer in QuickBooks and no invoice is checked off (or let’s say you haven’t posted one yet) then no income will show up on the P&L. In fact you will wind up with negative accounts receivable for that customer on the balance sheet.
Most QuickBooks Company files are set up with Accrual as the default method. The truth is that even though most small businesses pay taxes on a “cash basis” as soon as we are posting invoices and entering bills as opposed to just recording deposits and writing checks, we are functioning on an accrual basis. This makes sense because as a business owner, or controller or CFO you want to be able to analyze who owes you what. Without an invoicing system this would be difficult if not impossible.
So to re-cap – on a cash basis we recognize income and expenses when paid. On an accrual basis we recognize income and expenses when earned/incurred.
Watch the free video demonstrating what accrual vs cash looks like in QuickBooks