Accrual vs. Cash Accounting

When running a company, there is always one thing that keeps you up at night - your money. Keeping track of sales, expenses, and other relevant details can be stressful at times, but financial records play an integral part in the success of any business.

Businesses must choose between two common accounting methods when preparing and reporting their financial information: cash accounting and accrual accounting. The method that you select will depend on the type of business and your individual business needs, but both methods have pros and cons to consider before making your decision. The deciding factors between the two can wildly differ from one business to another and can affect your tax, financial reports, and even business decisions.

Ultimately, it’s up to you to decide between the two, but by understanding the basics of each approach and its impact on the financial health of your business, you’ll be able to make an informed decision that’s right for your business. We're here to break down what each one means so you can choose which is best for your business going forward!

In a nutshell

The main difference between these two methods lies in the timing of when revenue and expenses are counted. The cash method records transactions immediately upon the exchange of money. Once the “cash” is physically spent or received, that is when the money gets recorded. Accrual on the other hand focuses on anticipated revenue. This means that it counts revenue when the money is earned, and expenses when the money is paid. Both methods sound basic in concept, however, whichever you choose can have a major impact on your finances in practice.

Cash accounting

Explanation

Cash basis accounting is simple and straightforward. As anyone might think, cash accounting records transactions when the money is spent or received. The easiest way to picture cash basis accounting is through a product-based business. If you were running a lemonade stand, then you would count and record each sale as soon as a customer hands you the money in exchange for a lemonade. If you needed to charge an expense, such as buying more ingredients, the expense would be recorded once you go to the store and buy the items needed. Recording transactions this way allows you to track your money in real-time. This gives you a clear picture of how much money you have on hand and the ups and downs of spending and receiving.

Pros

Knowing how much is available to spend. With the cash accounting method, as you only count once the money is exchanged, you can accurately track cash flows, as you know almost exactly how much money your company has at any given time.

Control the timing of transactions. Another advantage to knowing the amount of money your business has on hand is that you can control how much you spend on a dime. If you were to start suddenly generating more sales, you can decide to spend more money investing in business operations for growth. More importantly, if your business were to hit a road bump, then you would be able to know immediately and stop spending to save more money on hand.

Delayed tax on transactions. The last advantage is that you only pay tax on money you actually have in hand, since you only count revenue when its received. When someone makes an order for your business, whether it be for a good or service, payment doesn’t always arrive right away. You might get a customer that wants to preorder a product, but will only be able to make the payment one month later. Under cash basis accounting, this transaction will not be recorded at the time they place the order, but at the time the customer actually makes the payment. Now imagine they place the order around the cutoff for yearly tax reports. Even though they placed the order in the current year, the transaction is not recorded yet. On your yearly tax report for the current year (2022) you won’t have to pay the tax for this order as when the payment is made it will count towards the next year (2023).

Cons

Single-Entry System. While a single-entry system used by cash-based accounting can be simple and straightforward, it has its limitations as well. This system is worse at tracking liabilities and assets, because of the way accounts receivable and accounts payable gets recorded. For companies that have a lot of assets, this can be an issue as it creates a muddier image of your company’s financial status.

Short-term financial reports. When you’re making long-term plans for your business, it is important to have foresight for any major changes in funds. Cash accounting will leave future finances unclear which will make it harder to accept new projects. Current fluctuations in cash flows can also skew the way you look at your business. Having an exceptionally positive or negative month can make the state of your business look more dramatic than it is.

Restrictions. According to the IRS, your choice of accounting method should properly reflect the income and expenses you report for tax purposes. In some states, you must use the accrual method unless you meet the IRS’s gross receipts test, and have average gross receipts in less than $26 million over the past three years. These are the general rules, but there are exceptions - so if you feel that your business falls into one of these categories, you should consult a professional.

Takeaways

Cash accounting is generally better if you have lots of transactions and deal directly with customers. This is good for basic products and services that don’t have complicated payment systems, which applies to the majority of businesses. This is also better for sole proprietors and smaller businesses, who will benefit more from having accurate cash flows where funding can be an issue in the early stages. They will also tend to have fewer accounts receivable and payable that aren’t anticipated in cash accounting methods.

Accrual accounting

Explanation

Accrual accounting records revenue and expenses when transactions occur, regardless of whether money is exchanged. Let's say you run an online product-based business. Your delivery time is 2 weeks. Because you want to build trust with your customers, you allow them to order the product first and pay once they receive it. In the accrual method, the transaction will be recorded at the time the product is ordered. This is called anticipated revenue as even though you haven’t received the cash for the payment yet, it is still recorded as a sale. This is an important distinction as it could completely change how a business's finances are pictured. Particularly for taxes, timing matters when the transactions are counted and paid out. In general, larger corporations tend to go with the accrual accounting methods. Some common examples of transactions that benefit from accrual accounting are: sales on credit, income tax expenses, rent paid in advance, insurance/electricity expenses, audit fees, and depreciation.

Pros

Better financial insight. TThe opposite of the cash accounting method,your company’s payables and receivables are recognized as income so they are on your financial statemnets, making it easier to plan future projects. This will give a more accurate report of your companies financial performance, as it will smooth out earnings over time. What this means is that it accounts for fluctuations that a business might have in sales, profit, etc, by looking at the overall picture of sales rather than current cash flows.

Cons

Cash on hand is not reflected in books. In the profit and loss statement, the cash you have on hand may not be accurately shown due to ARs and APs. This means that you have to stay on top of cash flow tracking yourself. When you record transactions before the money is exchanged, there may be a period of time when your bank account doesn’t match the books. This can be dangerous for cash flow and you may be led to believe you have more money than you actually do.

Early tax on income. As you record transactions early, you will also be taxed for these earnings earlier as well. If a sale were to take exceptionally long for you to receive your money, you may end up paying tax on your income without having the money received from that sale yet. If the client were to go back on their order and fail to pay you, then it gets complicated. You will be able to recover the losses on your tax return, however, you’ll have this isn’t clear, and take longer to receive your money back.

Takeaways

The accrual method is best for larger businesses and businesses that don’t get paid quickly. This is because larger companies will have a larger cushion in funding, and can generally afford to overlook small fluctuations in cash flows. A business might be profitable in the long term, but have little short-term cash. This can be a big deal for small businesses, but large businesses can power through that. In that case, they will prefer the benefits of in-depth financial reporting that the accrual method has to offer.

Help is available

When running a business, it's easy to neglect the numbers side of things. Bookkeeping is the backbone of any business and is the key to planning future goals. When you encounter hurdles in finance - such as choosing cash vs accrual accounting methods, don’t be discouraged. We strive to provide you with the resources needed for your business to thrive, and promote the success of small business owners.

If you are curious about what LedgerFi can do for you feel free to schedule a call and chat with us anytime!