In this article, we will cover:
- What is cash basis accounting?
- What is accrual accounting?
- Cash accounting: pros and cons
- Accrual accounting: pros and cons
- Final thoughts
As a small or medium-sized enterprise (SME) owner, you need to keep close tabs on your cash position. This means knowing exactly what you owe and are owed. But which is more important?
The answer will help dictate your choice between cash and accrual accounting. It’s a decision that could have major implications for your tax liability; how you run your accounting function; and what financial information you have available to support strategic decisions.
Companies generally account for incomings and outgoings using either of these 2 methods for tax filing and financial reporting. You can use 1 method for each—for example, accrual for tax and cash for financial reporting. You can even take a hybrid approach, providing it accurately reflects your income and is used consistently.
But when selecting a method for your tax filing, choose carefully. The IRS encourages companies to use the same method consistently and changing it can be difficult.
So, which to choose?
The difference between accrual versus cash accounting comes down to timing of work earned, expenses incurred, and payments.
With the cash basis, you account only for the money you receive and spend in a given period. With accrual accounting, you account for what revenue you’ve earned and expenses incurred, regardless of whether the payments for these are made before or after the period. As such, cash accounting is simpler, but accrual gives a more accurate picture of your company’s finances.
Understanding the difference between cash accounting versus accrual accounting is a fundamental step for relatively new businesses. When choosing between cash or accrual accounting you should align your choice with your operating model, future aspirations, and financial preferences.
Getting the choice between the 2 methods right could mean the difference between future growth or potential stagnation.
What is cash basis accounting?
Cash basis accounting tracks your business’ cash flow—when you receive money and when you spend it. When your clients pay you, you record revenue; and when your business pays suppliers and workers, you record expenses. This method does not cover accounts payable and receivable—in other words, what you owe and are owed—until the money changes hands.
Cash basis is the simplest type of accounting and is exempt from the requirements of Generally Accepted Accounting Principles (GAAP). Many SMEs use the cash basis due to this simplicity.
It means your business’ income is not taxed until the money is in the bank, which is vital for many small companies with tight cash flows.
However, using a cash basis won’t provide you with a complete picture of how your company is doing.
Advantages and disadvantages of cash-basis accounting
The cash basis is an easier approach to accounting for SMEs. You don’t need to track receivables or payables. It’s easy to tell when a transaction occurred—the money comes in or out of the bank. In the cash system, you do not pay taxes on funds you have not yet received. So, there is less risk of being unable to pay your taxes—a key point for many small companies.
Cash accounting shows you the actual account balances and makes it simple to discover how much cash your company has at any time. It gives you more transactional control, which may help improve cash management and tax benefits. For example, if a client tends to pay you in advance, you could ask them to delay that payment to the following year, if you would rather pay tax on it then.
However, because it does not take receivables and payables into account, cash accounting does not give a complete picture of your company’s financial position, including what you owe and what is owed to you. For example, if you have $10,000 in your bank account but owe $10,000 on an inventory order, cash accounting won’t reflect that. It will simply show you have $10,000. So, companies with large inventories generally can’t use cash accounting, even if they are small.
What is accrual accounting
With the accrual method, you record revenues and expenses when they are generated, regardless of when the money is collected or paid. So, for example, you record income when you finish a project and issue an invoice, not when that invoice is paid.
The accrual basis uses a matching principle, in which you match expenses to the revenue they help generate in the same period. If there is no cause-and-effect relationship between the expenses and revenue, you record those costs immediately.
For tax purposes, companies with over $26 million revenue in the previous 3 years must use accrual.
Lei Han, associate professor, Department of Accounting at Niagara University, says: “Most mom-and-pop shops will use cash accounting. However, if you’re still small but think you will grow to beyond $26 million revenue quickly, you may consider using accrual accounting now because it takes cost and effort to transition to it—including filing an IRS form and getting approval.”
You must also use the accrual basis if you want to use GAAP. Businesses with investors or loans tend to use the accrual basis in their financial statements because most lenders require GAAP.
Advantages and disadvantages of accrual basis of accounting
Accrual accounting is more common than cash accounting among larger firms. Using the accrual basis helps you track what’s owed in both directions, so it gives a more complete view of your company—one that can be viewed in some accounting software dashboards. This allows for more accurate analysis, forecasting and strategy. This is usually key in a large organization with lots of moving parts, including long-running projects, and credit offered to and from customers and suppliers.
Importantly, the matching principle also allows you to use depreciation to spread the costs of long-term assets such as machinery or real estate.
On the downside, numerous rules and regulations are associated with accrual accounting. It takes more time and effort than cash accounting, and you will probably need specialist accounting personnel. As well as this knowledge, there is much more work to do in monitoring and calculating work completed, payments in advance, accounts payable and receivable, and accrued liabilities.
With accrual accounting, you will have less awareness of your cash flow. Your business may appear highly profitable even though its bank account is empty. You need to accompany it with diligent cash-flow monitoring.
If you run out of cash in the short term, the consequences could be dire. To avoid this, many firms submit their taxes on an accrual basis, but keep their books on a cash basis.
Under the accrual method, you might also have to pay taxes on earnings you haven’t yet received. So, you need to plan carefully to ensure you have enough money to cover your tax bill.
Lei says another issue is that businesses need a performance effort to make a sale, then a collection effort reflected in your cash receipts. With cash accounting, it’s harder to separate the 2 and see if you need to improve your collection policies, for example.
Accrual gives a more accurate picture of that, especially if done in conjunction with careful cash-flow monitoring, she says.
“But you need more people to do the recording and analysis for accrual. In a company with many long-term projects on the go—say, in construction—it can take many professional judgements and adjustments to work out how much of the agreed service has been provided by the end of the year and make sure the correct revenue and expenses are recognized.”
Should you use cash or accrual for small business?
When you start out in business, you may not think which accounting method to use is an important decision. But, as shown here, it has so many critical consequences, you cannot ignore the question and need to think it through carefully.
- If your business is small, has shorter term projects, and lower revenue, choose cash accounting to make things easier and see cash flow clearly.
Should you use cash or accrual for larger businesses?
- If you run a larger business, have complex long-term projects, and a high amount of revenue, credit, and debt, choose the accrual method to gain a better understanding of your overall financial position. Just remember to also diligently monitor cash flow by other means.