Don’t run! This will be quick and painless. I won’t go into the legal ramifications of cash vs accrual here, but know that you can’t flip-flop between the two, and the IRS has restrictions on who can file as a cash-based business.
Rent is a relatable expense, so for this example let’s assume you pay rent to a landlord. Let’s dive in.
You rent office space for $500 a month. Rent is due on the 1st of every month and you pay by check. The recurring rent bill has already been entered in QBO by your bookkeeper. You record the rent payments when you write the check.
Jan 1, 2022 – Dec 1, 2022: Each month, you paid $500 to your landlord on the due date.
Jan 1, 2023: You paid $500 to your landlord on Dec 30, 2022.
Feb 1, 2023: You paid $500 to your landlord on the due date.
March 1 – Jan 1, 2024: You paid $500 on the 1st of each month.
Cash Basis Reporting
Your rent expenses on your monthly financial reports will show:
$1000 paid for rent in December 2022.
$0 paid for rent in January 2023.
$500 paid for rent in February 2023.
Your 2022 annual report will show 13 rent payments made for a total of $6500.
Your 2023 annual report will show 11 rent payments made for a total of $5500.
Accrual Basis Reporting
Your rent expenses on your monthly financial reports will show:
$500 for rent incurred in December 2022.
$500 for rent incurred in January 2023.
$500 for rent incurred in February 2023.
Your 2022 annual report will show 12 rent payments incurred for a total of $6000.
Your 2023 annual report will show 12 rent payments incurred for a total of $6000.
The difference between the two is that you track expenses either when they are paid or when they are incurred.
Now let’s take a quick look at rent as income.
The landlord received rental payments on the paid dates noted above: 13 payments in 2022, and 11 payments in 2023.
Cash Basis Reporting
The landlord’s 2022 annual report will show $6500 in collected income.
The landlord’s 2023 annual report will show $5500 in collected income.
Accrual Basis Reporting
The landlord’s 2022 and 2023 annual reports will each show $6000 in earned income.
The difference between the two here is revenue is reported either when it’s collected or when it’s earned.
Bonus
My clients may sometimes hear me refer to modified cash basis accounting. This means your books borrow tracking and entry methods from both cash and accrual-based accounting. This modified method of accounting gives you better insights into your monthly inventory, payroll, and upcoming expenses. Note that to be GAAP compliant, you must use accrual-based accounting. Only accrual-based accounting will give you a complete understanding of your business finances. For cash-based clients, I recommend borrowing from accrual to gain a better understanding of your finances.