The difference between cash and accrual accounting lies in the timing of when sales and purchases are recorded in your accounts. Cash accounting recognizes revenue and expenses only when money changes hands, but accrual accounting recognizes revenue when it’s earned, and expenses when they’re billed (but not paid).
We’ll look at both methods in detail, and how each one would affect your business.
Cash based accounting
The cash basis of accounting recognizes revenues when cash is received, and expenses when they are paid. This method does not recognize accounts receivable or accounts payable.
Many small businesses opt to use the cash basis of accounting because it is simple to maintain. It’s easy to determine when a transaction has occurred (the money is in the bank or out of the bank) and there is no need to track receivables or payables.
The cash method is also beneficial in terms of tracking how much cash the business actually has at any given time; you can look at your bank balance and understand the exact resources at your disposal.
Also, since transactions aren’t recorded until the cash is received or paid, the business’s income isn’t taxed until it’s in the bank.
Accrual based accounting
Under the accrual basis, revenues and expenses are recorded when they are earned, regardless of when the money is actually received or paid. This method is more commonly used than the cash method.
The upside is that the accrual basis gives a more realistic idea of income and expenses during a period of time, therefore providing a long-term picture of the business that cash accounting can’t provide.
The downside is that accrual accounting doesn’t provide any awareness of cash flow; a business can appear to be very profitable while in reality it has empty bank accounts. Accrual based accounting without careful monitoring of cash flow can have potentially devastating consequences.
The effects of cash and accrual accounting
Understanding the difference between cash and accrual accounting is important, but it’s also necessary to put this into context by looking at the direct effects of each method.
Let’s look at an example of how cash and accrual accounting affect the bottom line differently.
Imagine you perform the following transactions in a month of business:
- Sent out an invoice for $5,000 for a web design project completed this month
- Received a bill for $1,000 in developer fees for work done this month
- Paid $75 in fees for a bill you received last month
- Received $1,000 from a client for a project that was invoiced last month
The effect on cash flow
Using the cash basis method, the profit for this month would be $925 ($1,000 in income minus $75 in fees).
Using the accrual method, the profit for this month would be $4,000 ($5,000 in income minus $1,000 in developer fees).
This example displays how the appearance of income stream and cash flow can be affected by the accounting process that is used.
The effect on taxes
Now imagine that the above example took place between November and December of 2017. One of of the differences between cash and accrual accounting is that they affect which tax year income and expenses are recorded in.
Using cash basis accounting, income is recorded when you receive it, whereas with the accrual method, income is recorded when you earn it.
Following the above example, using accrual based accounting, if you invoice a client for $5,000 in December of 2017, you would record that transaction as a part of your 2017 income (and thus pay taxes on it), even if you end up receiving the payment in January of 2018.
How to choose an accounting method for your business
You’ll need to choose an accounting method when you file your first tax return, and then use it consistently on all subsequent returns. A trusted CPA can help you determine which accounting method is best for your business.
Be aware that some businesses are required to use the accrual method, so the specifics of your business may dictate which you choose.
To change accounting methods, you need to file Form 3115 to get approval from the IRS.
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Accrual accounting is also known as the accrual basis, or accrual method, of accounting. Its basic premise holds that transactions should be recorded when they occur and not when payments are actually received. Financial accounting, which forms the basis for constructing financial statements, relies heavily on the accrual basis. Accrual accounting is the alternative to the cash basis of accounting, which records revenues and expenses when cash changes hands.
The accrual method is required for (and favored by) most medium and large businesses, relegating cash accounting to small businesses and individuals. Certain financial arrangements create timing gaps between the provision of a service or good and the actual payment for the service or good; perhaps the most common example is a credit account or business loan. These payments may not actually be received during the same accounting period, necessitating the use of accounts payable and accounts receivable to track projected inflows and outflows. Under cash accounting, businesses that sell on credit are not able to report sales until the money is collected.
With accrued income and accrued expenses able to reflect business activity more accurately, investors and lenders have a better grasp of the operational efficacy and overall leverage of a company. The accrual method additionally requires that expenses and revenues match, which complements the matching principle as laid out in generally accepted accounting principles and reflected in the income statement and balance sheet.
Accruals can also be used for taxes and wages, helping to ensure that the full amount of these expenses is recognized. Managers and owners tend to prefer the accrual method because it provides a more accurate reflection of monthly expenditures and profit. For the most part, however, businesses do not have a choice. The Internal Revenue Service (IRS) requires that businesses use accrual accounting once they get big enough, and any business with an inventory must use the accrual method. Only qualifying small businesses can elect to choose between cash and accrual, and they must stick with their decision.
Smaller operations historically favored the cash basis of accounting due to its ease of use. While accrual accounting may have compelled the hiring of an accountant, cash basis accounting could often be handled with a small team or even by the sole proprietor him or herself. The permeation of enterprise software that can perform accrual accounting, such as QuickBooks, is slowly changing the small business reliance on cash accounting.
One negative consequence of the accrual basis of accounting stems from its tendency to ignore time. If a company relies heavily on credit accounts to generate sales, the accrual method does not provide an accurate account of real cash flow. This can cause problems if the company does not track cash flow separately and have an effective accounts receivable collections operation. This can also be of concern to investors and lenders that might see great revenue numbers listed on the income statement, only to later find out that collections were lacking and that the company cannot maintain operations. This is one of the reasons why the statement of cash flows is considered a core financial document.