Whether you are setting up a new business or running a well established one, it is important to know the basic differences between cash vs. accrual basis bookkeeping. It is also helpful if you are applying for a loan to understand why your banker wants to see your books in an accrual format.
Accounting standards in the United States are called Generally Accepted Accounting Principles (GAAP). These are the accounting standards for all U.S. businesses. GAAP recognizes and provides principles for both cash and accrual accounting methods, as does the Internal Revenue Service.
Generally speaking, cash basis bookkeeping recognizes income and expenses when they are received or paid. If you are a cash basis bookkeeper you may have accounts receivable but they don’t show as an asset on your balance sheet. Your accounts payable also don’t show up as a liability on your balance sheet.
Accrual basis bookkeeping recognizes income when goods or service is delivered and expenses are incurred. Income is recognized when it is realizable. Realizable means the company has every expectation that it will be paid for its goods and services in the future.
Any business can choose to be an accrual based bookkeeper, but the IRS has set some restrictions on what kind of businesses can be cash-based bookkeepers.
In general, a business can be a cash basis bookkeeper when it does not have inventory. This excerpt from IRS publication 583 explains the rule about determining accounting methodology:
"If you need inventories to show income correctly, you must generally use an accrual method of accounting for purchases and sales. Inventories include goods held for sale in the normal course of business. They also include raw materials and supplies that will physically become a part of merchandise intended for sale. Inventories are explained in Publication 538."
If you are an accrual basis bookkeeper, you don’t need to worry about how your financial statements will be reviewed by a lender. The accrual method should have all the income and expense items properly accounted for on the balance sheet and income statement. Accrual basis bookkeepers don’t have issues with income and expenses mismatching over two periods (a month or quarter) with each other.
Accrual bookkeeping shows a more complete and true picture of your company’s financial health than does cash basis bookkeeping. As you might imagine, a potential lender wants to see as complete a picture of your business as they can. We have created a commercial borrowing checklist (download it here) to help you know what to assemble before applying for a loan.
There are some good reasons why a business might elect to be a cash basis bookkeeper, but if you apply for a loan you will need to provide some additional information to your banker. You will need to have an accurate aging of your accounts receivable and accounts payable and show a schedule of any additional current obligations. If you use an accounting program like QuickBooks, you can select an accrual option when printing financial statements. If you do this, you should have accurate books for a bank to review as long as all of your payables have been entered when they were incurred in the QuickBooks system.
There are different stakeholders in your business: you, the management, any lenders who need to see your financial statements, any vendors who want to see your company’s financial statements so they can make trade credit decisions, and, of course, taxing jurisdictions.
As you think about your accounting methodology, remember that if you are a cash basis bookkeeper, some of the internal and outside stakeholders in your business will want to see your financial condition in an accrual format even though you are not an accrual basis bookkeeper for IRS purposes.