Cash vs. Accrual Accounting Methods: What is the best choice for your restaurant?
Making decisions – even small ones – about your business can have long-term ramifications if you don’t do your homework first. One of the most important decisions you make when opening a restaurant is choosing which accounting method to use for your financial reporting.
In a nutshell, you have two options: cash accounting or accrual accounting. Each has its strengths and weaknesses depending on the size of your business, your restaurant’s niche, and the growth phase you’re in.
The method you choose for your restaurant accounting affects when revenues and expenses are recorded.
Cash Accounting
For most non-accountants, cash accounting (aka “cash basis”) is the easiest method to understand. Under cash accounting, both revenue and expenses are recorded at the moment of receipt or payment. Pretty simple.
Income is booked when you receive cash or charge a credit card, not when a customer places an order with your restaurant. This is similar to how you manage your personal household with your checkbook. Under this method, it is not required to recognize revenue (and thus pay taxes) until you receive payment from your customers.
Example: Your business offers catering services, and you typically collect 50% of the payment upfront and 50% at the event. Under the cash method of accounting, you recognize 50% of the revenue when the customer places their order and 50% the day the food is delivered.
Under the cash method of accounting, expenses are booked as vendors are paid. This method gives you, within certain limitations, the freedom to control your restaurant’s bottom line. In other words, you can take expenses as your income statement needs them.
Example: On December 1st, your business ordered a shipment of napkins from a supplier, who has a trade credit of net 60. This means that they require payment within 60 days. Your tax accountant tells you that your annual tax return will be better if you put off paying that invoice until the next tax year. You pay that invoice on January 10th, well within the 60-day time period required by your vendor, and the expense is recorded on the next year’s income statement.
Accrual Accounting
Accrual accounting (aka “accrual basis”) is a bit more complex than cash accounting. Under accrual accounting, revenue is recorded as it is generated, and expenses are recorded as they are incurred, regardless of whether or not cash has changed hands.
Let’s look at the revenue side: income is booked at the time the sale is made, even if payment as not yet been received.
Example: Your business offers catering services, and you typically collect 50% of the payment upfront and 50% at the event. Under the accrual basis of accounting, you recognize all of the revenue when the customer places their order, even though you haven’t been paid in full.
When considering expenses under the accrual method, they are booked in the period you order, use, or consume the item in your business.
Example: On December 1st, your business ordered a shipment of napkins from your supplier, who has a trade credit of net 60. This means that they require payment within 60 days. Your tax accountant tells you that your annual tax return will be better if you put off paying that invoice until the next tax year. Even though you pay that invoice on January 10th, you must record the expense on December 1st, the day that you placed the order.
How do you know which method fits your business?
Both cash and accrual methods have their pros and cons. The cash method of accounting can be great for new businesses whose cash reserves are tight because it better matches taxable revenues with the cash received. However, your income statement won’t match your true financial position if income or expenses are expected but not yet recorded. On the other hand, the accrual method can be great for restauranteurs because it better matches revenues with related expenses. Seeing an income statement that represents your true financial position can help you make better business decisions.
While both cash and accrual are approved restaurant accounting methods for tax purposes, the use of the cash method is much more restricted. Often, a business just starting up will be able to use the cash basis until it earns more revenue. This allows for tax planning in the critical first year of operation. As your business grows, or if you begin accounting for inventory, you will probably need to switch to accrual.
What happens if your business changes? Can you switch methods?
In some instances, it might make sense, or even be a requirement, to change from one method to the other.
Some changes are “automatic”, meaning they do not require IRS approval; others require approval. A change may require you to file an extra form or two, and you will have to follow the IRS’s guidelines for determining your income in the year of change and in future years.
Our restaurant advisory group can help you determine the best accounting method for your restaurant. Contact us.
