It's the question all State-side business owners have: what accounting method to use? I don't know why Americans like to complicate their sh*t, because internationally it's quite simple: there is only one way to register transactions: by accrual.
But what is cash accounting and what is accrual accounting? Cash accounting is bullsh*t. It has no logical operational basis, at least in my eyes. Say you allow clients defer payments once sales have been finalized. Income must be recognized when the sale is finalized: as an account payable with a credit to sales. The account payable will be credited to when the client pays, whether in full or part of their balance. That's what the International Financial Reporting Standards (IFRS) say. That's what I learned in school back home.
In Mexico, income taxes for individuals is determined on a cash flow basis. For VAT purposes, individuals and corporations are also taxed on this basis. However, there is no financial reporting standard that provides for cash accounting. It's all accrual.
I feel like I've made a case without explaining to all of you what each method entails, so here it goes... I'll bore you with bleak details, daaaaaahlings!
Cash accounting
Cash accounting should be non-existent.
So, this accounting method basically revolves around cash. The accounting cycle in this method revolves around the flow of cash: receive cash and record it; spend cash and record it.
Cash accounting is easy for non-accountants, because it's easy to keep up with everything, since the recording of transactions revolves around the movement of cash. It is great for small businesses starting out due to its simplicity.
Cash accounting helps the individual or the business keep tabs on how much cash there is in the company or in an individual's wallet at any given time.
However, with its simplicity, it also has a few downsides. As cash accounting is very simple, companies that use this method are not very into accounting software, this leads to greater errors in accounting, as there is no mechanism to minimize the chance of f**king everything up.
While cash accounting helps businesses know how much money they have at any given time, it doesn't allow businesses to understand the bigger picture: cash accounting complicates the preparation of financial statements, as the method provides for a single entry system, and as such, there are no accounts per se.
Accrual accounting
Now this is real accounting!
This method is the only legitimate one in my eyes. In the accrual method, transactions are recorded when they are initiated. Revenue is recorded when earned and expenses when incurred, whether they have been collected and paid or not, respectively.
Accrual is the superior accounting method, to be honest. It is suited for businesses that sell on credit, with the principal benefit of this method being that it provides track of invoices, whether or not they have been collected.
It is also ideal to track balances for vendors. If you purchase goods and services on credit, you may keep track of what invoices have been paid or not.
That being said, you can track your accounts payable and accounts receivable. This is key to seeing the bigger picture: it allows for accurate preparation for financial statements.
In accrual accounting, one must employ the double entry method established by Luca Pacioli in 1494, which states that the sum of all debits must always equal the sum of all credits.
While I say this is the superior method, that doesn't mean it's perfect. Accrual accounting also has a downside to it. It doesn't allow for detailed cash control.
I read somewhere that another detriment to this method is its dependency on accountants and accounting software. But let's be clear: all businesses need a good accountant. There is no one more qualified to keep tabs on your business than your trusted accountant.
Accrual based accounting is great for large businesses that operate on credit and whose volume of transactions is quite hefty. However, I differ on this stance. Accrual is the accounting method par excellence. There is no other way of doing it: you either keep your books under the accrual method or don't keep books at all.
What happens when you operate on accrual accounting but are taxed on a cash flow basis?
Well... It's quite simple.
Let's run wild with our imaginations. Think about an individual who owns a business, whatever business floats your boat. According to reporting standards, they must keep their books using the accrual method, but are taxed on a cash flow basis. How will we ever know what revenue we will report in the income tax return?
Well, it's simple. When sales on credit are finalized, the journal entry will most certainly be a debit to Accounts receivable and a credit to the income account. When payment is collected, then the Account receivable will be credited. In the income tax return, we must consider as income the credits to Accounts receivable, as this is the income that has been effectively collected.
For deductions, we'll operate in a similar manner. When purchases on credit are finalized, our journal entry will be as follows: a debit to the expense account with a credit to Accounts payable. When we pay off our purchase invoices, then the Accounts payable will be debited. In the income tax return, we must consider as expenses the debits to Accounts payable, as these are the expenses that have been actually paid.
However, if you operate on both credit and cash transactions (by cash, in this case, we mean all of the transactions that are initiated and paid on initiation), then this will not be fully true to you. For credit transactions, you may operate on the basis mentioned in the two previous paragraphs, but for cash transactions, I do recommend you separate income and expense accounts on the basis of whether they are accrued or paid. So, the determination of income and deductions for tax purposes will be hybrid: consider the credits to Accounts receivable and credits to Cash income accounts as income and consider the debits to Accounts payable and debits to Cash expense accounts as deductions.
It's very simple, yet complicated at times.
Y'all know that if you have questions, you can just DM me :)
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