How to use Quickbooks in a cash basis business

Many small businesses, and particularly those without inventory, prefer to use a "cash basis" accounting system. Many of their accountants might prefer an accrual basis and small business accounting software may tend to default to that basis.

While there areadvantages and disadvantages to both, cash basis is often easier for a small businessperson to understand: you record income for taxing authorities when you actually receive or pay out money. With accrual basis, you'd usually record income when you create an invoice, even though your customer has not paid that bill yet, and you would record an expense when you receive bills from suppliers and others, even though you had not actually paid those yet.

Over the life of the business, the overall profits made and taxes paid will be identical, though a specific tax year may be higher or lower in one method than the other.

Some businesses have specific circumstances that make the choice more obvious. For example, much of my business is subscriptions that may or may not be renewed. It is convenient for me to create invoices showing the upcoming subscription renewals, but if I recorded those as income at that point (accrual basis), I would have a fair amount of unraveling to do if the subscription is canceled.

For example, consider a renewal that comes due in December. It's a $10,000 sale and is subject to sales tax in my State. I will also have $8,500 in expenses (licenses that I have to renew with my suppliers) that will occur if my customer does renew.

On an accrual basis, the profit ($1,500) will be part of that years income and I will have to pay the sales tax to the State in January. In fact, the sales tax may be due before I even know if the customer will renew!

I'm sure you can see where this can get complicated if the customer decides not to renew. I may have paid the sales tax and, in this particular case) I have closed out the fiscal year. It's a mess that I obviously need to clean up.

Plainly it is easier for me to use cash basis accounting. I would not owe the sales tax until I received payment on my invoice and, if the customer chose not to renew, I could simply delete that invoice and not affect anything at all.

Quickbooks

I have used Quickbooks for my small business accounting since 2001. I've had some problems here and there, but overall it has been a convenient way to do my accounting.

Quickbooks does allow a choice of cash or accrual basis accounting, but it can create some confusion. The reasons for this are explained in detail at Quickbooks "Why accounts receivable and accounts payable balances might show in cash basis balance sheet" article, but it basically comes down to what they say at the end of that article: "QuickBooks was not designed to be used in this way and reporting anomalies result".

Watch your settings

Actually, some of the anomalies come from not paying close attention to all settings. Choosing cash basis during company setup does not change the default settings of other items. For example, Sales Tax will default to accruing as of the invoice date rather than what you would probably want in this situation, which would be upon receipt of payment. You make that change in Company Settings->Sales Tax.

If you don't make that change, Sales Tax payable will appear on Balance Sheet reports even though you have told Quickbooks to report on a cash basis. This mixing of methods can be very confusing if you missed that one setting!

However, other confusion can come from entering bills to pay. As that Quickbooks article explains, you can eliminate some of that by changing the order of General Journal entries, but it is definitely annoying.

Credit card liabilities are another source of confusion. It's actual simple enough if you think about it: your vendor HAS received payment, therefore the expense is recorded even though you have not yet paid the credit card bill. Quickbooks explains this in more detail.

Overall, you need to be careful if you have set up Quickbooks to use cash basis. You may have very good reason, as I do, but many Quickbooks defaults are for accrual basis. You have to pay very close attention and be sure you understand the reports you are seeing.

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