You might have heard the terms “cash basis accounting” or “accrual accounting.” Your net income number can change depending on which method your books are set up for. Here’s a simple explanation of the difference, with a little help from one of the most famous cartoon characters in history.
Popeye and Wimpy
You might recognize Popeye the Sailor Man from the television cartoons or other media. His sidekick, Wimpy, was the one who was always hungry and always out of cash. One of his favorite sayings was, “I’ll gladly pay your Tuesday for a hamburger today.”
It’s All in the Timing
Let’s make today Thursday. If Wimpy wants to pay us Tuesday for a hamburger today, here’s how it would be done for a restaurant on cash basis:
Cash basis recording Wimpy’s hamburger purchase
Both the sale and the receipt of cash would be recorded on Tuesday. Companies on cash basis only record the transaction when the cash is received.
But, if the restaurant’s books were on the accrual basis, it would be a different story:
Accrual basis recording Wimpy’s hamburger purchase
Wimpy’s hamburger sale would be recorded on Thursday, the day he ate the hamburger. The receipt would then be recorded on Tuesday, assuming Wimpy made good on his promise to pay.
You might be asking why a few days is such a big deal. Outside of cartoon life, a couple of extra twists can happen. It can be far more than a few days from the time you do the work to the time you get paid for it. And often, these dates span different months and even years, affecting the amount you have to pay in taxes to various agencies. Manipulating these dates (legally, of course) is one of many tax planning strategies that we can help you with.
Choosing for Your Business
In many cases, the government has chosen which method you must use when it comes to sales tax, payroll taxes, and income tax. That’s part of the reason we make the required adjustments to your books at year end.
To help you run your business in a forward-thinking way, the accrual method is best. You can record invoices for work you’ve done even though you haven’t received payment yet. You can enter bills you need to pay before you pay them to forecast cash requirements. Using accrual accounting, you can budget for cash flow needs as well as see more accurately what your revenue and income is looking like.
For clients who remain behind in their bookkeeping and just want to catch everything up once a year, the cash basis is adequate. However they lose out on all the good information they could have had throughout the year to run their business better.
For other businesses, a hybrid approach between cash and accrual accounting can be the most cost effective.
A Little Help from Popeye the Sailor
What would Popeye say about all this accounting talk?
“That’s all I can stands, cuz I can’t stands n’more!”