Understanding the differences and which you should use for your business
Want to know if you should choose cash or accrual for your small business? Schedule a free call with one of our accounting experts to discuss the pros and cons for your business.
What’s the difference between cash and accrual?
The difference between cash basis accounting vs accrual basis accounting is based on when your revenue and expenses are reflected in your books.
Fact: Contrary to popular belief, the difference between Cash and Accrual accounting has nothing to do with the method of payment.
In a nutshell, when you receive payment from your customers and then immediately write it down in your books, that’s cash accounting. But if you wait until the product is delivered or service is rendered before you write it in your books, then that’s accrual accounting.
The same goes for your expenses.
When using cash accounting, If you buy goods but don’t pay for them right away (ie. you put it on credit or negotiate other terms with your supplier) you don’t write it in your books until it’s actually paid for. But if you put it in your books right away (as money owed or an “account payable”) then that’s accrual accounting. It’s best to stay consistent with whichever you choose and the IRS requires companies to keep the same method for an entire year - you cannot switch half-way through (want to switch accounting methods? File IRS form 3115) there are also some hybrids (I’ll talk about these later in this article)
Basically, when using cash accounting method, you wouldn’t recognize accounts receivable or accounts payable. Accrual accounting recognizes both of these.
On a deeper level, accrual accounting allows you to match up revenue and its corresponding expense starting when the transaction occurs, rather than when payment is transferred. This method lets you understand the current cash flow and compare it to future cash flow (on a transactional basis).
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Pros of Cash Accounting
Cash accounting is simple and handy. It allows you to know how much cash you have in the bank in real-time, and you only have to pay taxes on the money you’ve received - you do not need to pay taxes on the money that’s owed to you.
Be sure to read the IRS website for specifics.
Cons of Cash Accounting
Cash accounting can have its drawbacks, too. It can give you an inaccurate long-term financial picture of your company. For example, if your business has a lot of money coming in it could lead you to believe you’re having a good month, but in actuality it’s last months sales that are just coming in now.
Since cash accounting does not include accounts receivable or accounts payable, it will be difficult to keep track of money when your company does not receive immediate payment or if you have outstanding bills to vendors. This will make it more challenging to manage your cash flow because it will not be clear what's coming in and going out over the next few days, weeks, or months.
Pros of Accrual Accounting
Accrual accounting gives a clearer picture of your business finances, as described by the Generally Accepted Accounting Principles (GAAP) . Accrual accounting is the best for understanding financial data because it shows how much money you earned and spent (aka your cash flow) within a specific period of time. This shows your cash flow broken up into transactions which is how you will know how well your business is performing - this shows when things pick up and when they slow down.
Having your cash flow illustrated through transactions is more finely illustrated with the matching principle. In accounting, the matching principle is defined as matching revenue and its corresponding expense within the same transaction, rather than when the expense or income is actually generated (from a timeline perspective).
For example, let’s say in January you buy 1000 units from your wholesaler then sell those units over a year. The sale you made in August is now being linked back to your wholesale purchase in January to show the full circle of your cash flow and the transactions that affect it.
Since accrual accounting shows these details, most business owners will choose to switch to accrual accounting at some point within the business lifecycle. By opting for accrual from the start you’ll be ahead of the game. Then once you hit 5 million in revenue, GAAP forces you to use accrual accounting.
When you use accrual accounting, you don’t have to pay taxes on orders/services until they’re fulfilled. For example, if you receive prepayment from a client, you won’t be taxed on that prepayment until you fulfill their order or service. This lets your company keep more money in the business until a future tax period. This extra money can help with operations or growth.
Cons of Accrual Accounting
Accrual can be more work because you have more lines to enter (ie. accounts receivable and accounts payable) and because you need to make sure those lines are posted in the correct period. Since you’re entering these extra lines, you’ll need to pay taxes on them even though you may have not yet received the income or paid for the expense.
An inaccurate short-term view is also something to consider since the cash method gives you a better view of your bank funds. This means that accrual accounting can be financially devastating to a small business - your books could show a large amount of revenue when your bank account is completely empty.
While accrual can be more work, you can set up accounting software to do the heavy lifting. Our preferred accounting software is Xero
- it can read your bills and enter numbers straight into your expenses column using the cash or accrual method. It can also record invoices as income when you send them.
Maybe a hybrid is best for your business?
Some small businesses choose a hybrid of cash accounting and accrual accounting - they might use accrual for inventory but cash for income and expenses.
You could also keep two sets of books - you could operate your business on accrual accounting, but then report to the IRS with cash accounting (when you report your books to the IRS with cash accounting, you don’t have to pay taxes on any of your product or services that are prepaid)
If you’re still unsure on which accounting method to use, schedule a free call with one of our accounting pros today.