Just like in a sporting event, with business you need to keep score. This is done through a dreaded record keeping process known as the accounting and bookkeeping. Accounting married with Finance can help you determine how well-off your company is doing as a whole but can also provide insight as to specific aspects of your company, such as individual products, product lines, customer payment tendencies, or could show where you’ve been slacking on your budget. Before deciding what type of accounting software you decide to choose you will need to determine the overall method to recording your business’s transactions. This is known as deciding what ‘Basis of Accounting’ you will abide by.
There are 2 main types of Basis of Accounting for you to choose from as well as a ‘modified’ basis which is a combination of the two. Below outlines what each of them are as well as will hopefully provide you with a working understanding of them to make an informed decision.
Please reach out and consult with your personal CPA and possibly you Attorney for these matters and their opinion on what would be most beneficial and cost effective for you.
Cash Basis
Cash Basis of Accounting is the simplest way to document or record your company’s transactions. It is the task of inputting transactions whenever money comes in or leaves the bank and/or physical cash is received or given for payment. This means that you document bills and expenses when they are paid and only consider revenue earned, when the cash comes in or is received.
This way of documenting the financial happenings of your business does not include utilization of common accrual-based accounts such as Accounts Payable, Accounts Receivable, Prepaid expenses, and Deferred Revenue.
This way of recordkeeping will contain cash and cash equivalents within almost every transaction and mirrors the bank statements for the company to show the financial health of the company.
Modified Accrual / Modified Cash Basis
The Modified Basis is a combination of the two main options. This option is a hybrid where the Cash Basis is utilized for some areas such as still expenses and income, but other accounts such as Inventory, Long Term Debt, and Fixed Assets are taken into account. A rule of thumb to consider is that for long term accounts you will utilize the accrual basis of accounting while short term accounts are under the cash basis.
Modified can be molded differently based on your company’s circumstances and what is cost beneficial you. This method is for internal purposes because the IRS requires smaller businesses to choose between the two main types (Accrual and Cash). Once you get to a certain threshold, you are required to be under the Accrual Method for tax purposes as it projects the most accurate representation of the company.
Accrual Basis
The accrual basis is considered to be the most accurate portrayal of a company and is the only option that complies with Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS). These are the regulatory accounting frameworks for both the United States and the majority of the world.
So, what is the Accrual method? The accrual basis for accounting is run by one overarching rule : Transactions are ‘booked’ or recorded when they occur, not when cash changes hands. From an income statement point of view, revenue is recognized when the services are performed or when goods are exchanged (when revenue is ‘earned’). For revenue recognition, please further refer to ASC 606. There is no correlation to if / when cash comes into play. Whether cash changes hands during the transaction slightly changes how it is documented. See the example below:
A customer comes in and you provide a service, which you’ve priced at $100:
If the customer pays with cash right then and there:
DR: Cash (increases) $100
CR: Revenue (Increases) $100
If you give them a month to pay and send them a bill reminder:
DR: Accounts Receivable (Increases) $100
CR: Revenue (Increases) $100
The same concept is implemented for bills and expenses. So, whether or not you pay for the service or good at the time of the event, you will ‘book’ or record this as an expense when it was incurred (the service was provided or good received). If you pay with cash, it will drop by the amount you paid, but if you are given a timeframe to pay back on a later date, it is entered as an accounts payable.
There are also other accounts to be aware of and understand when you enact this basis such as deferred revenue and prepaid expenses, among others which involve discrepancies of when cash is received or paid vs when the transaction occurs.
As mentioned above, once your company meets a certain threshold, it is a requirement for tax purposes to utilize the accrual method, so if aspirations for growth are in your plan, you may want to think ahead for this future recordkeeping requirement.
It is an important note to consider that if you are in need of your financial statements to be either formally reviewed, or audited this is the method that will need to be utilized. Audits and reviews give a comfort to your investors that your financial statements are materially accurate. An audit or review may be required now or in the future for your business if you are interested in obtaining financing through an institution or an outside investor.