If you’re in the midst of getting your business finances in order, you’ve probably noticed that some services offer cash-basis accounting, while others offer accrual-basis accounting.
Okay, maybe you haven’t noticed, because the topic of cash vs accrual accounting isn’t exactly the most exciting thing to talk about.
But as snooze-inducing as the difference cash vs accrual accounting may be, there are a few things you need to know about if you want to keep proper track of your business finances. Though both cash-basis accounting and accrual-basis accounting track money coming in and money going out, there are important differences between the two—differences that can change the way you run your business.
To help you understand cash vs accrual accounting (without putting you to sleep), we’ve broken down the basics.
The Difference Between Cash vs Accrual Accounting
The biggest and most important difference between cash-basis accounting and accrual-basis accounting is the timing of when income and expenses are recorded. If you record a transaction when you pay someone or receive a payment, it’s cash-basis accounting. However, if you record a transaction when you get a bill or submit an invoice, it’s accural-basis accounting.
Let us explain.
Cash-basis accounting only recognizes income and expenses when money changes hands. This means that income is only recorded when the money actually hits your account and expenses are only recorded when the money leaves your account.
For example, imagine you are a plumber that has just fixed someone’s sink and billed them for the service. The income that you earned from the job is only recorded when the person actually pays you for that service. So if you bill the client on April 17th and they don’t pay you until May 1st, the payment will not be recorded until May 1st.
Similarly, if you receive a phone bill, you would not record the expense until you actually pay the bill. Therefore, if you receive the bill on September 15th, and don’t pay until October 1st, you would not record the expense until October 1st.
Accrual-basis accounting is a little bit more complicated than cash-basis accounting, but is the most widely used in business. In accrual-basis accounting, income is recognized when it is earned and expenses are recognized when a bill comes in.
For example, imagine you’re a design firm that has just been hired to create a new logo for a local business. You would record the income from that project as soon as the work is complete—even if the client has not actually paid the bill yet. So if you complete the work on July 7th, but the client doesn’t pay until August 1st, you would still record the income earned on July 7th.
The same is true of expenses. If you receive an Internet bill, that expense is recorded as soon as the bill comes in—even if you haven’t paid it yet. So if your internet bill arrives June 14th and you pay on July 2nd, the expense is still recorded on June 14th.
The Advantages and Disadvantages of Each Method
By now, you probably have a pretty clear understanding of the difference between cash vs accrual accounting.
But with two different methods of accounting to choose from, how do know which to use?
Well, there are benefits and downsides to each.
The advantages of cash-basis accounting:
- It’s simple and easy to maintain.
- It’s easy to track how much cash the business actually has at any given time because the money is simply in or out of your bank account.
- You only have to pay tax on the money you’ve received, rather than on invoices you’ve issued. For some businesses, this can help cash flow.
The disadvantages of cash-basis accounting:
- It can be misleading because it may show that you are profitable when you simply haven’t paid your bills yet.
- It is unhelpful when it comes to making business decisions because you only have a day-to-day view of your finances, rather than a long-term perspective.
The advantages of accrual accounting:
- It gives you a more accurate picture of your business finances and performance.
- It’s helpful when it comes to making strategic business decisions because you can be more confident about your overall financial situation.
- Allows you to budget faster and more strategically because you’re not only tracking what you have in the bank right now, but also what is coming in and going out over time.
- It can be beneficial when projecting your company’s future financial health. This is especially important when seeking funding from lenders and investors.
- You can claim expenses on the tax form for the year you incur an expense, rather than in the year you actually pay them.
The disadvantages of accrual accounting:
- It can be more work because you have to keep a watchful eye on accounts receivable. In other words, you could have several outstanding, but no actual cash in the bank.
- You may have to pay tax on income before it actually hits your bank account.
When to Use Cash vs Accrual Accounting
It’s obvious that cash-basis accounting is a far simpler method to maintain. As a result, cash-basis accounting is generally used by sole proprietors and very small companies that deal almost exclusively in cash. In other words, cash-basis accounting works best for business with very straightforward finances.
However, for businesses that are focused on growth, like startups, accrual accounting is a far more powerful tool. Startup founders need the right financial data in order to make business decisions that will lead to growth. With the right information at your fingertips, you can better understand your investments, build accurate financial forecasts, and create plans for future fundraising rounds. To do all this, you need data that is forward-looking and the only method that offers this perspective is accrual-basis accounting.
Accrual accounting is not only the best way to track your business’ performance, but it’s also necessary for situations such as courting investors, applying for a business loan, or any other activity that may require you to share your books with an outside party.
Moreover, accrual-basis accounting is actually required in specific cases, including:
- If your business has sales of more than $5 million per year, or
- If your business stocks inventory that you will sell to the public and your gross receipts are more than $1 million per year.
It is also worth noting that accrual accounting is a core element of Generally Accepted Accounting Principles (GAAP) and all publicly traded companies must be GAAP-compliant. Even if you’re a private company, this is an important consideration for the future.
Sure, it’s true that accrual accounting does require a little more vigilance. However, most of the heavy lifting can be done by advanced accounting software, while a professional bookkeeping service like OpenDigits can take care of the rest.