Welcome to the Rigits guide to understanding cash vs. accrual accounting!
Choosing between cash and accrual accounting methods is more than a technical decision; it’s about finding the fit that reflects your business activities accurately and helps you plan for the future.
This article is designed as a comprehensive guide to help you make an informed decision between cash and accrual accounting. We’ve broken down the concepts into bite-sized, understandable sections tailored specifically for small business owners like you.
This guide is also related to our articles on understanding prepaid expenses, understanding gross vs. net profit, and modified cash basis accounting.
In this guide, we’ll cover:
- Cash basis and accrual basis
- Benefits and drawbacks of each method
- Comparisons of the two
- Modified cash accounting
- Switching between methods
- Real-life examples
By the end of this guide, you’ll have a solid foundation to choose the accounting method that will best support your business’s financial health and growth.
Let’s dive in!
Cash vs. accrual in a nutshell
The key difference between cash and accrual accounting lies in the timing of when sales and purchases are recorded in your accounts.
In cash accounting, transactions are recorded only when cash changes hands. For example, if you invoice a client, it only goes on your books when they pay you.
Conversely, accrual accounting records transactions when they are earned or incurred, regardless of when the payment is made or received. So, if you invoice a client, it’s counted as revenue immediately (increasing Accounts Receivable), and when you receive a bill, it’s considered an expense right away, even if you’ll pay it later ( increasing Accounts Payable).
For instance, under accrual accounting, if you perform a service in December but don’t get paid until January, you still record the income in December. This distinction offers a more accurate picture of your business’s financial health at any given time, but it requires keeping track of more financial transactions than cash basis accounting.
Cash Basis Accounting
Cash basis accounting is as straightforward as it sounds. It’s like your business’s bank statement; you see what comes in and what goes out, real-time. For many small business owners, this simplicity is appealing because it provides a clear snapshot of where cash stands at any moment.
Pros
Simplicity: It’s easy to understand and manage. You don’t need to be a finance whiz to keep your books in order.
Cash Flow Clarity: You have a direct view of how much cash is available, which is crucial for managing day-to-day operations and planning short-term finances.
Cons
- Limited Financial Overview: Cash basis can sometimes give a misleading picture of long-term financial health because it doesn’t account for money you’re owed but haven’t received yet or expenses you’ve incurred but haven’t paid.
- Not Ideal for Larger Businesses: As businesses grow, especially those with inventory or that extend credit to customers, cash basis accounting won’t capture the full complexity of their financial situation.
Accrual Basis Accounting
Accrual basis accounting offers a more comprehensive view of your business’s financial health. With this method, transactions are recorded when they’re earned or incurred, regardless of when the cash is actually exchanged. This means you record invoices as income when you send them, not when they’re paid, and you record expenses when you receive the bill, not when you pay it.
Pros of accrual basis accounting
- Complete Financial Picture: It provides a more accurate view of your business’s financial status by accounting for all earned revenues and incurred expenses within the period they occur.
- Actual profitability: Regardless of when your customers pay, when your vendors get paid, or when you order inventory, you’ll see exactly what expenses match your income for a picture of your real profitability.
Cons
Complexity: It requires a more sophisticated understanding of accounting principles and often a more detailed bookkeeping process.
Cash Flow Management: Since it doesn’t track cash movement in real-time, you might find it challenging to gauge their available cash without additional cash flow analysis.
| Feature | Cash Basis Accounting | Accrual Basis Accounting |
| Definition | Records transactions when cash changes hands. | Records transactions when they are earned or incurred, regardless of cash movement. |
| Cash Flow Clarity | Provides a clear picture of actual cash inflows and outflows on the Profit & Loss. | Offers less immediate clarity on cash flow since transactions are recorded when recognized, not when paid. |
| Financial Reporting | Simpler financial statements, easier for small business owners to manage. | More complex financial statements that provide a comprehensive view of the business’s financial health. |
| Complexity | Low; straightforward to implement and maintain. | High; requires a more detailed tracking and understanding of financial transactions. |
| Suitability | Best for small, cash-based businesses or those with minimal inventory and credit transactions. | Preferred by businesses that have significant inventory, credit transactions, or need to follow GAAP standards. |
Modified Cash Accounting
Modified cash basis accounting blends the straightforward cash handling of daily transactions with the more complex accrual method for specific areas. This hybrid system allows small businesses to enjoy the simplicity of cash basis accounting while still capturing critical financial data through accrual methods in certain scenarios.
Two common adaptations of modified cash basis accounting are focusing on Accounts Payable (AP) and Accounts Receivable (AR), and handling Inventory and Cost of Goods Sold (COGS) separately.
Hybrid Approach 1: Cash Basis Except for AP and AR
In this scenario, a business uses cash basis accounting for most of its financial transactions but applies accrual basis accounting to manage its Accounts Payable and Accounts Receivable.
This means that daily operational transactions are recorded when cash is exchanged, offering simplicity and clarity on cash flow. However, when the business sends invoices (Accounts Receivable) or bills from vendors (Accounts Payable), those invoices and bills are displayed in financial statements on the invoice or bill date, not when payment is made or received.
Benefits
- Financial Accuracy: By accounting for receivables and payables as they occur, businesses can achieve a more accurate representation of their financial position, reflecting obligations and income more realistically.
- Simplicity: Rather than full-blown accrual, only customer invoices and vendor bills make up the hybrid approach.
Hybrid Approach 2: Cash Basis Except for Inventory and COGS
In the second scenario, businesses record most transactions on a cash basis but switch to accrual for handling inventory purchases and the cost of goods sold.
In cash accounting, all inventory gets immediately expensed as cost of goods sold (COGS) when it’s purchased – no inventory sits on the Balance Sheet.
By recording inventory purchases when they’re made (regardless of when they’re paid for) and COGS when products are sold (not when the inventory is paid for or used), businesses can more accurately assess their profitability and manage their stock levels.
Benefits
- Enhanced Profitability Analysis: This method allows for a more accurate calculation of gross profit by aligning revenue from sales with the costs associated directly with those sales.
- Inventory Management: Keeping track of inventory on an accrual basis provides insights into stock levels and the timing of inventory purchases, creating better inventory management.
Both scenarios of modified cash basis accounting offer small businesses the flexibility to manage their finances effectively, providing the simplicity of cash transactions for everyday activities while incorporating the accrual method’s detailed insights where they matter most.
When a Business Should Change Its Accounting Method
Transitioning between accounting methods is a significant step for any business, reflecting its growth, changing needs, or a desire for a more comprehensive understanding of its financial health.
When to Consider a Change to Accrual Accounting
Business Growth: As businesses expand, the simplicity of cash accounting might no longer provide the depth of financial insight needed for accurate decision-making.
Regulatory Requirements: Meeting the standards set by governing bodies or preparing for external audits may necessitate a switch, especially for businesses that have reached a certain size or are seeking investment.
Operational Needs: Changes in business operations, such as offering credit to customers or managing large inventories, may make accrual accounting necessary.
The Process of Adjusting the Books
Recognize Accrued Expenses and Revenues: Identify any revenues earned but not yet received and expenses incurred but not yet paid. If these revenue and expenses are not in invoice or bill form, you typically adjust with a journal entry. The entry would look something like this:
Accrued revenue
- Credit Sales (for income earned but not received yet)
- Debit Accrued Income
Accrued expense
- Debit Expense (for expenses incurred but not paid yet)
- Credit Accrued Expense
When your customer pays or you pay your vendor, those above journal entries would get reversed, clearing out Accrued Income and Expenses.
Account for Inventory: If not already doing so, begin accounting for inventory on an accrual basis, recognizing COGS when goods are sold, not when they’re paid for.
Count your current inventory, and move it out of COGS into an Inventory asset account on the balance sheet.
When sales are made, expense only the COGS related to sales, and move those COGS out of inventory.
Account for Prepaid Expenses: If you prepay for, let’s say, a year’s worth of insurance, this needs to be set up as a Prepaid Expense, which is an asset. Each month, as you use that month’s worth of insurance, you would decrease Prepaid Expense and increase Insurance Expense.
Accrue Payroll: If employees are paid every two weeks, you may need to accrue payroll if it doesn’t get paid until the following month. For example:
Employees get paid on the 1st and the 15th of the month. The payroll run on the 1st of the month is for work in the previous month. To accrue, you would debit (increase) payroll expense and credit (increase) Accrued Expense.
When the payroll comes out of the bank account, reverse the accrued entry.
Set up Depreciation and Amortization: Typically your CPA will adjust depreciation and amortization on your fixed and intangible assets at the end of the year. However, for full accrual accounting you should be recognizing these expenses monthly. Get your depreciation schedules from your CPA which will tell you their useful life and depreciation method, and make the monthly adjustments.
The monthly entries will increase depreciation/amortization expense and increase Accumulated Depreciation/Amortization next to your Fixed Asset section on your balance sheet.
Examples of Cash and Accrual Approaches
The choice between cash and accrual accounting methods can significantly impact a company’s financial management, reporting, and strategic planning.
To illustrate this, let’s explore two hypothetical examples of companies: “Fresh Start Landscaping,” a small, service-based business that could benefit from a cash accounting approach, and “Innovate Tech Solutions,” a rapidly growing tech startup where accrual accounting would be more appropriate.
Fresh Start Landscaping: A Case for Cash Accounting
Fresh Start Landscaping is a small, locally-owned landscaping business operating in a suburban community. It provides services such as lawn maintenance, garden care, and small-scale landscaping projects primarily to residential customers. The business is owned and operated by its founder, Alex, who manages a small team of part-time employees.
Why Cash Accounting Suits Fresh Start
Simplicity: Fresh Start’s transactions are straightforward, consisting mostly of immediate payments for services rendered and expenses paid out for supplies and wages. Accrual accounting would overcomplicate a system that’s working well.
Clarity on Actual Transactions: Cash accounting allows Fresh Start to concentrate on the transactions that have an immediate impact on their operations without the distraction of pending or projected financial events.
For a small business, the ability to concentrate on tangible financial activities helps to avoid the confusion and potential misinterpretation associated with accruing revenues and expenses that have been earned or incurred but not yet realized in cash form.
Tax Benefits: Using cash accounting, Fresh Start can strategically time income and expenses to optimize tax liabilities. For example, by scheduling certain payments or delaying invoicing towards the end of the fiscal year, Alex can manage taxable income more effectively, reducing the tax burden during leaner months.
Innovate Tech Solutions: A Case for Accrual Accounting
Innovate Tech Solutions is a tech startup that specializes in developing software solutions for small to medium-sized businesses. The company has experienced rapid growth, expanding its client base and increasing its staff. It operates on a subscription model, where clients pay monthly or annually for software access, and it also engages in long-term projects that span several months.
Why Accrual Accounting is Ideal for Innovate Tech
Complex Financial Transactions: Innovate Tech’s business model involves deferred revenues (from subscriptions) and accrued expenses (such as salaries for its software developers and costs related to long-term projects). Accrual accounting provides a more accurate picture of financial health that reflects the company’s ongoing operations and obligations.
Revenue Recognition: With a subscription-based revenue model, accrual accounting enables Innovate Tech to recognize income evenly over the subscription period, aligning revenue with the period in which services are provided. This approach provides actual profitability numbers, leading to better financial planning, budgeting, and performance evaluation by accurately matching income with related expenses.
Investor and Lender Requirements: As Innovate Tech seeks investment and financing to fuel its growth, accrual accounting becomes essential. Most investors and lenders require financial statements prepared under Generally Accepted Accounting Principles (GAAP), which favor the accrual method. These detailed financial reports provide stakeholders with a clear understanding of the company’s profitability, cash flow, and financial position.
Conclusion
We’ve gone over the key differences between cash and accrual accounting in this guide, laying out the pros and cons of each to help you figure out what’s best for your business. We touched on why cash accounting might be your go-to for its simplicity and direct cash flow insight, and how accrual accounting could offer a more detailed view of your business’s financial health, despite being a bit more complex to manage.
Also, we looked at a hybrid approach that could give you the best of both worlds in some situations. And importantly, we talked about when and why you might consider switching between methods as your business grows and changes. By now, you should feel more equipped to choose the accounting method will work for you!
Here’s to making informed decisions that support your business’s success!
Next, check out our articles on 14 bookkeeping statistics you need to know, how to hire a virtual bookkeeper, and what are back office services.
FAQ: Cash vs. accrual accounting
Here's some answers to commonly asked questions about cash vs. accrual accounting
Can a small business switch from cash to accrual accounting, or vice versa?
Yes, a small business can switch between cash and accrual accounting. However, the transition requires careful planning and may need approval from the IRS or relevant tax authority, particularly if the switch affects how income and expenses are reported for tax purposes.
It’s essential to file the appropriate forms and possibly adjust past entries to align with the new method. Consulting with a financial advisor or accountant is recommended to ensure the switch is made smoothly and in compliance with all legal requirements.
How does the choice between cash and accrual accounting affect business taxes?
With cash basis accounting, taxes are paid on income when it’s received and expenses are deducted when they are paid. This can sometimes offer flexibility in managing taxable income year-to-year.
Accrual basis accounting may lead to paying taxes on income before it’s received since income is recorded when earned. This method provides a more accurate picture of a company’s financial health but can affect cash flow during tax payment periods.
Is one method better for financial analysis and planning?
Accrual accounting is generally considered better for financial analysis and planning because it provides a more accurate picture of a company’s financial performance and position. It accounts for all revenues earned and expenses incurred, regardless of when cash is exchanged.
Accrual accounting helps businesses make informed decisions, plan for the future, and attract investors or lenders by adhering to Generally Accepted Accounting Principles (GAAP). However, for small businesses focused on day-to-day cash flow, cash basis accounting might be simpler and more straightforward to manage.
