Cash Based vs Accrual Based Accounting: Which is Right for Your Business?
Most entrepreneurs and business owners are visionaries and strategic thinkers who thrive on creativity and grand ideas, and not so much on data or numbers. They often prefer big-picture thinking over the nitty-gritty details, which is why many business owners find the financial side of running a business—like bookkeeping and accounting—challenging and unappealing. However, the financial side of the business is just as important as the creative side of running a business. Outsourcing these tasks to an accounting expert can free you from the day-to-day financial details, allowing you to focus on what you do best: growing your business.
An experienced accounting partner can manage your finances and craft a financial strategy tailored specifically to your business needs. This includes advising on key decisions like choosing the right software for your business and recommending the appropriate accounting method to ensure that your business’s financial practices align with your strategic goals.
In this article, we’ll break down the differences between the two methods of accounting – cash accounting and accrual accounting – to help you determine the best approach for your business.
What is Cash Basis Accounting?
Cash based accounting or cash accounting is a simple method of accounting in which revenue or expense transactions are recorded when cash is received or paid out, not when the revenue is earned or the expense is incurred.
This method of accounting focuses on cash flow, with a particular emphasis on cash on hand. This method is most often used by small businesses and for personal finances that don’t have a lot of complexity.
What Types of Businesses are Ideal for Cash Accounting?
The cash basis accounting method works well for businesses that don’t carry inventory, don’t buy or sell on credit, and for businesses that are paid relatively quickly after products or services are delivered.
Smaller businesses including sole proprietorships prefer cash accounting over accrual accounting. Some examples of businesses that are well suited for cash-based accounting include restaurants, retail stores, personal service businesses like hair salons, nail shops, and similar businesses.
What is Accrual Basis Accounting?
In contrast, the accrual method of accounting is more complex than cash accounting. The accrual accounting method records revenues and expenses when they are earned or incurred, regardless of when cash is actually received or expenses are actually paid. It is also known as accrual basis accounting or the accrual method. Accrual-based accounting provides a more accurate financial representation of a company’s operations by recognizing revenues and expenses as they occur and not when the cash is received or paid out.
Accrual accounting utilizes accounts payable and accounts receivable to formulate an accurate, real-time picture of a company’s financial status. Using this method generally evens out the income and expenses earned and incurred by a company and minimizes large swings created when cash exchanges hands.
What Types of Businesses are Well-suited for Accrual Accounting?
The accrual accounting method works well for medium to larger sized businesses and those that have delays between receiving cash and paying bills, accept or make credit card payments, or hold inventory are ideal candidates for accrual accounting.
Furthermore, businesses that have more than $25 million in sales over three years are required by the IRS to use accrual accounting. In addition, publicly traded businesses that are required to file audited financial statements must follow Generally Accepted Accounting Principles (GAAP) in recording and reporting their finances. GAAP sets the standard accounting rules for preparing, presenting, and reporting financial statements in the U.S. and its goal is to ensure that a company’s financial statements are complete, consistent, and conforms to an accepted set of standard accounting practices.
Many non-publicly traded companies utilize the accrual-based accounting method because it gives businesses a more accurate financial picture. This accounting method is regarded as more sophisticated than the cash method and is favored by lenders and creditors, so if the business ever needs a loan or line of credit, an accrual accounting method will increase the chances for approval.
Advantages and Disadvantages of Cash vs. Accrual Accounting Methods
There are clear advantages and disadvantages of cash basis and accrual basis accounting, and while accrual basis accounting offers most businesses a better glimpse into their overall financial health and conforms to generally accepted accounting principles, it does come with more complexity than the cash method of accounting.
The Pros and Cons of the Cash Basis Method
One of the biggest advantages of cash accounting is that it’s a much simpler method than the accrual method, and easier to manage for a business owner. Below are the biggest advantages and disadvantages to cash accounting:
Advantages:
- Simplicity: Cash basis accounting is notably simpler than the accrual method, making it easier for small business owners to implement and manage. This method directly tracks cash flow, providing a clear and immediate understanding of how much cash is available.
- Immediate Financial Overview: With transactions recorded when cash changes hands, business owners have an instant snapshot of financial activity, which simplifies the management of incoming and outgoing cash.
Disadvantages:
- Limited Financial Insight: One significant drawback is that cash basis accounting offers a narrow view of long-term financial health. It does not match revenue with the expenses incurred to generate that revenue, which can lead to misleading profit figures during periods of significant cash inflows or outflows.
- Difficulty in Long-Term Planning: Without the ability to foresee or plan for future incomes and expenses, cash basis accounting can make it challenging to perform effective business planning or forecasting. This approach also makes it difficult to measure profitability by client or project and productivity by staffing resources.
- Lacks Comprehensive Financial Controls: Unlike accrual accounting, cash basis accounting does not account for receivables, payables, and other important financial metrics like depreciation and amortization. This may necessitate additional procedures to manage credit effectively.
- Non-Compliance with GAAP: Financial statements prepared under cash basis accounting do not comply with Generally Accepted Accounting Principles (GAAP), which can be a significant drawback when seeking external financing or engaging with investors, as most prefer GAAP-compliant reporting.
As your business matures and your financials become more complex, you can switch from cash to accrual accounting, but because the transition can be tricky, it’s advisable to lean on an accounting expert like AURA.
The Pros and Cons of the Accrual Basis Method
There are many advantages to using the accrual method including gaining a more accurate financial picture. However, it comes with some complexity. Below is a quick summary:
Advantages:
- Enhanced Accuracy: The accrual method provides a more comprehensive financial picture by aligning income with the expenses incurred to generate that income, regardless of when cash transactions occur. This alignment helps businesses match revenues with expenses, leading to smoother financial statements and more predictable cash flow patterns.
- Improved Financial Planning: By recording transactions when they are earned or incurred, accrual accounting makes forecasting and budgeting more straightforward. This is particularly advantageous for businesses engaged in project-based work, where tracking time, expenses, and profitability by client and project is crucial.
- GAAP Compliance: Accrual accounting meets Generally Accepted Accounting Principles (GAAP) standards, making it necessary for businesses that seek financing, attract investors, or are preparing for an IPO.
Disadvantages:
- Complexity: Accrual accounting is more complex than cash basis accounting. It requires a thorough understanding of accounting principles and may demand more resources to manage effectively.
- Cash Flow Tracking: While accrual accounting offers a clear view of profitability, it can complicate the direct tracking of cash flow, as revenues recorded may not immediately correspond to cash received. Nevertheless, with accurate accounting records prepared by an organization like AURA, using accounts receivable and accounts payable records, companies can easily project their cash flow on a regular basis.
- May Be Overly Complex for Some: For small businesses that operate primarily on a cash basis without credit transactions, the benefits of accrual accounting may not justify its complexity.
Businesses that rely solely on cash payments may find accrual accounting unnecessary, as it is more beneficial for those extending credit, billing on an irregular cycle, or dealing with payment delays.
Below is a comparison chart that shows the primary differences between the two accounting methods.
Tax Implications of Cash and Accrual Accounting
Before deciding on the accounting and financial reporting method to implement for your business, it’s important to understand the tax implications of each of these accounting strategies.
Cash basis accounting may delay tax payments until cash is received while accrual accounting may require tax payments on revenue that has been recognized, even though the company has not yet received the cash for some of those transactions.
Examples of Cash Basis Accounting Method
Scenario 1: A wholesale business sells $5,000 worth of products in March, but doesn’t receive payment from the buyer until April.
Cash-Based Accounting: In this method, the transaction is recorded when cash actually changes hands. So, despite making the sale in March, the revenue is not recorded until April when the payment is received.
Scenario 2: A company pays $1,200 in advance for a year’s worth of insurance coverage in January.
Cash-Based Accounting: In cash-based accounting, the full $1,200 payment is recorded as an expense in January, the month when the payment is made. There is no recognition of prepaid expenses or allocation over the period the service covers, which impacts their cash flow in January.
Examples of Accrual Basis Accounting Method
Scenario 1: The same wholesale business sells $5,000 worth of products in March and issues an invoice, but doesn’t receive payment from the buyer until April.
Accrual-Based Accounting: Under this method, revenues and expenses are recorded when they are earned or incurred, regardless of when the cash is received or paid. Therefore, the $5,000 sale is recorded in March when the sale actually occurs, not in April when the payment is received.
Scenario 2: The same company pays $1,200 in advance for a year’s worth of insurance coverage in January.
Accrual-Based Accounting: Under accrual-based accounting, the $1,200 payment is recognized as a prepaid asset initially. Each month, $100 of this prepaid amount is expensed to reflect the insurance coverage for that month. Therefore, the expense is spread evenly over 12 months, recognizing $100 each month as the actual expense.
These scenarios further demonstrate how the timing of expense recognition can differ significantly between the two methods, affecting how financial statements reflect the company’s financial position and operations.
Choosing the Right Accounting Method for Your Business
As illustrated, several key factors influence whether cash or accrual accounting is the better method for your business. Gaining a clear understanding of these differences is crucial for business owners to make well-informed decisions regarding their accounting practices. This knowledge ensures that the selected method aligns with your business’s financial goals, reporting requirements, and operational needs.
If you’d like to discuss these two options in greater detail with a team of experts, contact AURA for a complimentary discussion. We can also help you transition smoothly from cash basis accounting to accrual basis accounting. We’re just a call or click away.