What is the difference between cash basis accounting and accrual accounting?
- Carrie Gajda
- May 25
- 6 min read
Cash and accrual accounting are akin to sibling rivals in the accounting world—distinct yet undeniably similar. Understanding how each operates is crucial, even if you're not directly managing your financial reporting, as it enables you to select the most effective bookkeeping practices for your business.
The primary distinction between cash and accrual accounting is the timing of when financial transactions are documented. Cash basis accounting records revenue and expenses at the moment cash is received or disbursed. In contrast, accrual accounting records these transactions when they are earned or incurred, irrespective of the actual cash flow.
Cash Basis Accounting:
This method records revenue upon receipt of cash and expenses when they are disbursed. It is a straightforward approach, frequently utilized by small businesses or individuals who do not require a comprehensive analysis of their financial performance over time. As long as annual sales are below $25 million, you may choose between cash basis accounting and the accrual method. Under this system, income is documented as it is received, and expenses are recorded as they are paid. Cash basis accounting only captures expenses when funds are withdrawn from your account to pay suppliers, vendors, and other third parties.
It is important to note that this method does not consider accounts receivable or accounts payable. This is because it solely pertains to payments from clients—whether in the form of cash, checks, credit card receipts, or gross receipts—at the time payment is received.
Let's take a look at an example of cash basis accounting:
When an invoice for $1,000 is issued to a client on March 1 and payment is received on April 15, the income should be recorded for the month of April, reflecting the actual receipt of funds. The process is as follows:
The invoice is issued for $1,000 in March
No action is taken in March
Payment is received in April
The income is recorded in April
Who uses cash basis accounting?
Due to its simplicity, numerous small businesses and sole proprietors opt for the cash basis method as their main accounting approach. For businesses generating less than $25 million in annual sales and not directly selling merchandise to consumers, the cash basis method may be the most suitable option.
Some advantages of this method include:
A shorter learning curve
Fewer items to record
Simplified tracking of expenses and revenue
What is the accrual method of accounting?
Under the accrual accounting method, income and expenses are recorded at the time they are billed and earned, irrespective of when the actual payment is received. According to the generally accepted accounting principles (GAAP), accrual accounting is required for financial reporting, as it offers a more accurate representation of a company's financial situation.
Example of accrual accounting
For instance, if a small business issues an invoice for $1,000 to a client on March 1, this amount should be recorded as income in the bookkeeping records for March, regardless of whether the payment is received by April 15.
The invoice for $1,000 is issued in March.
Revenue is recorded in March.
This principle also applies to accrued expenses. For example, if your small stationery business purchases paper supplies using a credit card in June but settles the bill in July, the expense should still be recorded in June. Here is the breakdown:
Paper supplies are purchased in June.
The expense is recorded in June.
Who uses accrual accounting?
While it is entirely permissible for small businesses to employ accrual accounting as their main accounting method, it is not mandatory. Nonetheless, in accordance with GAAP regulations, any business that is publicly traded or generates over $25 million in sales revenue over a three-year span is obligated to adopt the accrual method.
Accrual vs. cash basis: Which is better?
Accrual accounting is the preferred choice for those prioritizing popularity, as it is the most widely adopted and provides the most comprehensive view of a company's financial health. Nonetheless, cash basis accounting remains a popular alternative due to its straightforward process.
Advantages and disadvantages of accrual accounting
In contrast to cash basis accounting, which offers a clear short-term perspective of a company's financial position, accrual basis accounting provides a more comprehensive long-term view of the company's performance.
This approach accurately reflects the income earned and expenses incurred within a specific timeframe, offering a clearer assessment of business fluctuations throughout a quarter or an entire year. Furthermore, accrual accounting adheres to nationally accepted accounting standards, ensuring that even as your business expands, there would be no need to alter your accounting method.
Advantages:
Provides a more precise financial overview: It offers small business owners a clearer understanding of income and accrued expenses over a certain period. This insight helps you and your accountant gain a comprehensive view of consumer spending patterns, enabling better planning for peak operational months.
Adheres to GAAP standards: The accrual method complies with GAAP, making it mandatory for companies with annual sales exceeding $25 million. Although this threshold may be high for many small businesses, they may opt for the accrual accounting method if required by their bank.
Adapts to business growth: While you may not meet the threshold now, your revenue could double or triple in a few years, surpassing the $25 million mark. If you already use the accrual accounting method, it seamlessly scales with your business growth.
Disadvantages:
Resource-intensive: Many small business owners find it more complex and costly to implement due to its intricacy and additional paperwork. Since revenues are recorded before cash is received, cash flow must be monitored separately to ensure bills are paid monthly.
Potential for inaccurate short-term perspective: The cash method provides a clearer view of available funds in your bank account. Without meticulous bookkeeping, the accrual accounting method could pose financial challenges for small business owners, as books might reflect significant revenue while the bank account remains empty.
Advantages and disadvantages of cash basis accounting
The cash method of accounting offers several advantages, such as ease of use and enhanced cash flow. Although it is the simpler of the two most prevalent accounting methods, it also presents certain limitations.
Advantages:
Simplified, familiar process: Cash basis accounting involves a straightforward bookkeeping approach akin to personal financial management. It is easy to track cash movements in and out of bank accounts since there is no requirement to record receivables or payables.
Income taxes: For tax purposes, you are not obligated to pay taxes on any funds not yet received. For example, if you invoice a client or customer for $1,000 in October and receive payment in January, you will not pay taxes on that income until January of the following tax year. This can be vital for individuals and very small businesses when cash flow is limited.
Disadvantages:
Inaccurate financial picture: Since it does not account for all incoming revenue or outgoing expenses, the cash accounting method may create an impression of high cash flow in a particular month, which may actually be due to activities from previous months.
No accounts receivable or accounts payable records: Due to its simplicity, this method does not require your CPA or bookkeeper to track the exact dates of specific sales or purchases. Consequently, there are no records of accounts receivable or accounts payable, which can pose challenges when payments are delayed or bills remain outstanding.
Doesn’t conform to GAAP: If your business surpasses $25 million in annual sales, updating your accounting practices becomes necessary. If you anticipate your business could exceed $25 million in sales soon, consider adopting the accrual accounting method when establishing your accounting system.
How to Select the Appropriate Accounting Method for Your Business
For small businesses that primarily conduct cash transactions and do not maintain extensive product inventories, the cash accounting method offers a convenient and reliable means to monitor revenue and expenses with minimal bookkeeping requirements.
However, for a more precise and current assessment of your financial health, accrual accounting may be the preferred option. Several other factors should also be considered.
Business Complexity
The industry you operate in and the complexity of your financial records may determine which accounting method is more sustainable. For instance, a business with multiple accounts, a large workforce, and various LLCs should likely avoid cash basis accounting, as it does not provide a comprehensive view of the company’s financials on the income statement, balance sheet, or cash flow statement.
Sales Revenue
Your choice between accounting methods can also be influenced by sales revenue. According to GAAP standards, businesses with annual revenues exceeding $25 million are required to use the accrual method. While this may not currently affect many small businesses, it is a consideration for future growth.
Publicly Traded Companies
Companies that are publicly traded or plan to go public must adhere to GAAP guidelines, which stipulate the use of the accrual accounting method. This ensures an accurate portrayal of financial health to shareholders.
Moving forward
Before proceeding with your small business accounting checklist, it is crucial to determine which accounting method to adopt for your business. While it is possible to change methods later, transitioning can be more challenging once you have become accustomed to a particular approach.
Ultimately, whether you select cash or accrual accounting, it is essential to comprehend both options thoroughly and ensure compliance with the GAAP requirements applicable in your state.
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