Accrual vs cash basis accounting is basically a matter of timing. The accrual method immediately recognizes expected revenue and expenses, while the cash method reflects actual revenue and expenses.
In this post, we’ll explore this difference further and talk about how to decide which method you should use.
What Is Accrual Accounting?
Accrual accounting is the most popular method because the Financial Accounting Standards Board (FASB) accepts it under their generally accepted accounting principles (GAAP). This method records revenue and expenses when you earn or spend, even if the business has not yet received or given payment.
In terms of revenue, accrual accounting requires a revenue entry when you deliver an order, not when the customer pays for it. The key here is recording revenue when you successfully deliver products or services to the customer. This involves an expectation of payment in the future. That could be a few hours or a few days or even a few weeks. What matters is that you account for revenue when you earn it rather than when you receive payment for the work you did or the product you sold.
Similarly, you would make an expense entry when you acquire equipment or supplies for the business, not when you pay for them. The same goes for services that you engage or order but do not necessarily pay for immediately. You simply record it when you make the transaction.
What is Cash Basis Accounting?
Cash basis accounting is the second most popular method because it is very simple. You recognize revenue and expenses when money exchanges hands. Note that because of this, cash basis accounting does not account for when transactions occur. It just records when you receive revenue and pay expenses.
So, you might ship an order out to a customer today, but you do not record it as revenue until you receive payment from that customer. You may also hire someone today to take product photos for you, but you do not record that expense until you actually pay them for the work. This means you will not report any revenue on your income statement unless you have the cash in hand. You will also not have any expenses on file that you have not yet paid for.
What Are the Main Differences Between Accrual and Cash?
1. Long-term Profitability
One major difference between accrual vs cash basis accounting is projecting profits and losses.
Accrual accounting records everything as transactions happen. This gives you a more accurate look at what business you closed and what expenses you incurred. With accounts receivable and accounts payable, you can see expected revenue and expenses over a long period. This gives you insight on the profitability of your company over the long term. You can also see if and how your profitability fluctuates seasonally. All you need to do is isolate a certain period of time to see all the transactions recorded there.
If you have investors, accrual accounting can help you. This method will show them the sales in the current quarter that are both paid and unpaid. This reflects greater revenues than the cash method would. With cash accounting, especially in the fourth quarter, retailers can look extremely profitable. In Q1, though, after the holiday buying frenzy, they would look overly unprofitable.
Since the accrual method doesn’t track cash flow, however, a warning is in order. Any business using this method must monitor this because the company may look profitable on paper but in reality has major cash challenges in the short term. The same warning applies to cash accounting when you do not pay expenses upfront. This can make your business look overly healthy when in reality there are large payables due the following month. Your business may be cash-rich right now but your payables exceed your current revenue stream.
Cash Basis Accounting
Cash basis accounting shows you basically what money you are actually holding right now and what money you have paid out. You can’t see what you will receive soon or what you need to pay for soon.
Cash accounting makes it very difficult to plan your next move. Say, for example, you look at the expenses for one month. It just so happens that you invoiced some customers between the 28th and the 30th for their orders. You did not receive those payables yet by the last day of that month. Your business could therefore look like it’s going under. The reality, of course, is that you will see those payments reflected in the following month.
2. Ease of Use
Because it is more complex, accrual vs cash basis accounting will probably mean that you need to hire additional staff to keep the books straight. The cash method is super simple and makes cash flow tracking really easy.
3. Tax Law
Accrual vs cash basis accounting may be necessary under GAAP. The Tax Cuts and Jobs Act states that business taxpayers with under $25 million in annual gross receipts on average for the past three years can use cash basis accounting. Anything over this necessitates the accrual method. If you run an S corp, even if you average more than $25 million a year, you can use cash accounting. Otherwise, the IRS requires accrual accounting.
Note that you may still use cash accounting for bookkeeping and then file your taxes using the accrual method. Just make sure that you keep a record of transaction dates if you decide to do this.
What’s an Example of Accrual vs Cash Basis Accounting?
Imagine that your business sells clothing. Say you sell $500 worth of shirts one day. With accrual vs cash basis accounting, you immediately record that as revenue of the day instead of when the customer pays you. If you get an electric bill and you do not pay the same day, you would still record it on that day instead of when you pay it.
How Do You Decide Which Is Best For Your Business?
The cash method is mostly used for personal finances and by small businesses making under $25 million a year. This method is advantageous for sole proprietorships in particular. It is so simple that you probably don’t need to hire any help unless you just don’t want it on your plate so you can focus on other growth tasks in your business. If, however, you file audited financial statements, then you’ll need to use the accrual method. Publicly-traded companies also use the accrual vs cash basis method.
If your focus is to know exactly how much money you have on hand at any given time, cash accounting is the best method for you. You can immediately see when money comes in and goes out. Another advantage is that you do not pay taxes on any income until you actually receive the money. If you carry a lot of inventory, however, the accrual method is the best choice.
Accrual vs cash basis accounting is simply recording revenue and expenses when transactions occur vs when you receive or spend money. Accrual accounting gives you a clearer picture of your business’s health over the long term by showing accounts payable and accounts receivable. Cash basis accounting, however, provides cash flow information.
If you need help with your bookkeeping and handling accrual or cash basis accounting, we’re here to help at EcomBalance. Schedule a call to speak with us or request a custom pricing quote and we’ll reach out to chat more about your business.