What Is the Difference between Cash and Accrual Accounting?Cash and accrual accounting are two methods bookkeepers, accountants, and small-business owners (like you!) rely on to manage their books. Both methods have strengths to recommend them—and crucial weaknesses too.
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 smallest of small businesses can use cash-based accounting, as can freelancers and individuals. However, the IRS prohibits certain types of businesses from using the cash accounting method, including these:
- Businesses that manage inventory
- Businesses that make more than $5 million a year
- Businesses that trade publicly on the stock exchange
Cash basis pros and cons
- Snapshot of short-term finances
- Clear look at immediate cash flow
- Inaccurate picture of long-term business trends
- No conformity to GAAP (generally accepted accounting principles)
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.
The US government uses a set of generally accepted accounting principles, or GAAP, to regulate how certain companies file their financial documents (among other things). Cash accounting doesn’t conform to these well-known accounting principles, which doesn’t necessarily mean you can’t use it—just that you should weigh your options carefully and consult with an accountant or bookkeeper, if possible, before proceeding.
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.
- Track time and expenses
- Create custom invoices
- Accept online payments
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.
Accounts receivable (AR) refers to money a client owes you. Under the accrual method, accounts receivables are logged as current assets on your balance sheet.
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.
Accrual basis pros and cons
- More accurate picture of long-term financial health
- Better description of current assets and liabilities
- Potential for paying income taxes on unearned income
- Less clarity on immediate cash flow
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.
No matter which accounting method you end up using, plan to get familiar with three crucial financial documents that help you track cash flow, spend accurately, and track income:
- Balance sheets, which show if your assets equal your liabilities
- Income statements, which list your profits and losses to calculate your net income
- Cash flow statements, which show how much cash is flowing into and out of your business
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.
If you sell any sort of inventory or make more than $5 million a year, you don’t have a choice: accrual-basis accounting is the only method for you. And that’s great news! Sure, accrual-basis accounting is the more complicated method, but it’s also more accurate. Plus, most accounting software defaults to it anyway; you’ll definitely want to familiarize yourself with the method, but you can leave a lot of the technical details up to your software.
Sell services rather than goods? You might have the choice between the two methods, and accounting software like Xero, QuickBooks Online, and Patriot Software all let you choose your preferred accounting method during the setup process.
Whichever way you choose, the accounting method you use will govern your books for a good long while—so make sure you choose wisely.
Want more bookkeeping know-how? Our article on bookkeeping basics for small-business owners can help you keep your books in order.
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