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Understanding the two types of accounting methods is a major milestone in more clearly understanding your financial statements. Here are some differences, pros, and cons of using cash versus accrual accounting.
Cash Accounting
When you select the Cash accounting method, Quickbooks filters the report to show income and expenses that have been received or paid during that time period. For example, ABC Business makes a $1,000 sale on June 18th, and receives payment on June 25th. $400 in payroll for wages from June 15th - June 30th are paid on July 5th.
Using cash accounting, the Income Statement for June would look like this:
Income: $1,000, Expenses: $0, Net Income: $1,000
Many small businesses prefer cash accounting because it reduces the quantity of transactions the enter into Quickbooks. It also turns the Profit & Loss Statement into a semi de facto Statement of Cash Flows, a financial statement that is particularly perplexing for many business owners. (Read our Demystifying the Cash Flow Statement blog post here!)
Another pro for using cash accounting is you only have to pay income or sales tax on money you have actually received. This is especially helpful for retail businesses who sell items on terms. If you sold an $80,000 Rolex in December, you'll only be responsible in sales & income tax for the portion of that sale you've actually collected.
The downside to cash accounting? It doesn't give you as accurate of a picture of your business's profitability as accrual accounting. It is also limited to businesses with less than $5 million in annual revenue.
Accrual Accounting
Accrual accounting introduces deferred and accrued income and expenses (also known as Accounts Receivable and Accounts Payable). When selecting accrual accounting, Quickbooks filters the report to show income and expenses that have been earned or incurred during that time period, instead of when they were paid, the opposite of cash accounting.
Accrual accounting more closely reflects the core-accounting principle of matching: reporting an expense in the same time period as the revenue that it helped generate. Reporting income and expenses in this way helps small-business owners read their Profit & Loss Statements to measure their business' operating profitability.
To use the same example as above, using accrual accounting, the Income Statement for June would look like this:
Income: $1,000, Expenses: $400, Net Income $600
As you can see, the accrual method is a much better measure of how $400 in Payroll was used to generate $1,000 in sales. This information can help business owners in determining sales commissions, budgeting for the future, and making hiring decisions.
Selecting an Accounting Method in Quickbooks Online
The great thing about Quickbooks Online (QBO) is that you can follow one accounting procedure and select cash or accrual reporting on your report and it will give you whichever report you prefer.
When you look at your Quickbooks Online Profit & Loss report, there is a toggle button called Accounting Method, and gives you the option of Cash or Accrual.
Need more help understanding cash versus accrual accounting? Contact us here.