When you set up your company's books, one of the most fundamental decisions you will make is choosing an accounting method. The two primary methods are cash basis and accrual basis. The method you choose determines the timing of when you record revenue and expenses, which in turn affects the story your financial statements tell. Dappr will ask you which one to use during the onboarding.
Dappr supports both methods, but our standard reports are generally discussed from the perspective of the accrual method, which is the standard for most businesses. This article explains what cash basis accounting is and how it specifically impacts your Income Statement, Balance Sheet, and Cash Flow Statement.
What is the difference?
The distinction between the two methods comes down to timing.
Cash Basis Accounting: This method is simple. Revenue is recorded only when cash is received, and expenses are recorded only when cash is paid. It mirrors the activity in your bank account.
Accrual Basis Accounting: This method provides a more accurate picture of a company's financial performance. Revenue is recorded when it is earned (i.e., when you've delivered the product or service), and expenses are recorded when they are incurred (i.e., when you've received the goods or service), regardless of when the cash actually changes hands.
Let's look at a practical example:
You are a consultant and complete a $10,000 project for a client in December. You send the invoice on December 15th, but the client doesn't pay you until January 31st.
Under the accrual method, you would record the $10,000 revenue in December, because that is when you earnedit.
Under the cash basis method, you would record the $10,000 revenue in January, because that is when you received the cash.
The same principle applies to expenses. If you receive a $500 bill for software in December but don't pay it until January, accrual accounting records the expense in December, while cash basis records it in January.
How cash basis affects your financial statements
Choosing the cash basis method will significantly change how your financial reports look and what they represent.
Impact on the Income Statement
A cash-basis Income Statement reflects your cash flow more directly than your operational profitability for a given period.
Revenue will only appear after a customer's payment has been deposited.
Expenses will only appear after you have actually paid a bill.
This can make your profitability appear "lumpy" or uneven. A month where you did a lot of work but collected no cash might show a loss, while the next month could show a massive profit when all the payments come in. While simpler, it can make it harder to see the true performance of your business operations during a specific period.
Impact on the Balance Sheet
This is where the most significant structural differences appear. Under a strict cash basis system, some key accounts that are central to accrual accounting simply do not exist.
Accounts Receivable: This is the account that tracks money owed to you by customers. Since cash basis accounting only recognizes revenue when you receive the cash, there is no concept of "receivables." Your Balance Sheet will not show who owes you money.
Accounts Payable: This is the account that tracks money you owe to your suppliers. Since cash basis accounting only recognizes expenses when you pay them, there is no concept of "payables." Your Balance Sheet will not show a complete picture of your upcoming financial obligations.
This simplifies the Balance Sheet, but it also means the report provides less information about your company's short-term financial position.
Impact on the Cash Flow Statement
The Cash Flow Statement is designed to reconcile the accrual-based Net Income from the P&L back to the actual change in cash. However, when you use the cash basis method, your Net Income already reflects your cash movements.
As a result, on a cash-basis set of books, the Net Income on your Income Statement will be nearly identical to the Cash Flow from Operating Activities on your Cash Flow Statement. The report is still useful for clearly separating your cash flows from investing and financing activities, but its primary function of adjusting for non-cash items becomes less critical.
Choosing the right method
Many small businesses start with the cash basis method due to its simplicity. However, it's important to know that the IRS requires businesses to use the accrual method in some cases, such as when their average annual gross receipts exceed a certain threshold (which changes over time).
The choice is often between simplicity (cash basis) and a more accurate picture of financial performance (accrual).
Dappr is not an accounting firm and this content is not tax or legal advice. You should consult with an accounting professional to determine the best accounting method for your specific business needs and to ensure you are compliant with IRS regulations.