What Is the Difference between Cash and Accrual Accounting?

Are you a small-business owner just setting up your books? You need to decide which type of accounting you're going to use to manage your business's finances: cash basis or accrual basis.

If you use cash-basis accounting, you won't record financial transactions until money leaves or enters your bank account. And if you use accrual-basis accounting, you'll record transactions as soon as you send an invoice or receive a bill, not when the money changes (virtual) hands.

Both types of accounting have pros and cons, but—spoilers—accrual-basis accounting is more accurate, and if you manage inventory, it's the method the IRS requires you to use. Keep reading for our more in-depth explanation of the two bookkeeping methods to get a better understanding of which one is right for you.

Cash-basis accounting is the simplest and easiest to manage of the two accounting methods. Like we said above, that means it's less accurate—more on that later.

With this method, you record financial transactions when cash enters or exits your account. You don't record any income from a project until a customer pays you. Similarly, you don't record a deduction for a bill until a creditor accepts your payment.

For example, if your building's utility payment is due on the last day of the month, you won't record the expense until the money leaves your account, which might happen the next month depending on bank processing times. And if you wrap up a freelancing project in June but don't get paid by your client until mid-July, July is when you'll add the income to your general ledger.

The cash method of accounting seems pretty logical until you consider that many business owners do all the work for a project months before getting paid. For example, if you pay for a project's expenses in July but don't record any income until October, July seems super unprofitable while October seems wildly successful—and that's not an accurate view of your business's long-term financial health and stability.

And while cash-basis accounting can give you a quick, up-front look at how much cash you have on hand at any given moment, it doesn't account for bills you've accrued but haven't yet paid. One month might look more profitable than it actually is only because you haven't paid off any expenses accrued during the month.

One perk? Since you don't record income until you physically receive it, tax time can be a little less stressful—you'll only pay income tax on money you already have for the tax year.

With the accrual method of accounting, you don't wait until the cash changes hands to record financial transactions; you record them instantly. If a client's order generates certain expenses on your end, you record the revenue from the order as soon as the invoice goes out and the expenses as soon as you incur them.

So let's say you get your monthly utility bill on the last day of August. The payment isn't due for 30 days, so if you used the cash method, you'd wait until September to record the expense since that's when you'll actually pay the bill. With the accrual method, though, you'll record the transaction in August, as soon as you receive the bill.

If accrual-basis accounting doesn't measure how much cash is physically in your bank account, how is it more accurate than the cash method? Because instead of hyper-focusing on the exact time a transaction occurred, it focuses on what you earned and what you owed in a given period. That kind of information gives you (and crucial stakeholders, like shareholders or creditors like banks) a better understanding of long-term business trends, not to mention your business's overall profitability.

But since the accrual method doesn't keep strict tabs on your cash flow, that particular task is up to you. After all, if you have more accounts receivable than invoices paid, you could end up spending money you don't actually have. If you use the accrual bookkeeping method, you'll want to frequently draw up accurate cash flow statements so you can make wise on-the-ground decisions about when and how to spend your (actual) money.

The accrual method can also make your taxes a little wonky. For instance, if you send out an invoice in December but don't get paid until the next January, you'll pay income taxes for the tax year before you actually receive the money. Of course, we're talking about taxes here, so go straight to the source—that'd be the IRS—for a better explanation of how the accounting method you choose can impact your tax season.

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