Cash vs. accrual accounting: Which is right for your business?
In accounting, there are two primary methods—accrual and cash basis. The main difference between accrual vs. cash accounting is in how and when you record income and expenses in your books. Each accounting method has advantages and disadvantages.
If you’re not familiar with accrual vs. cash basis accounting, we’ll help you understand what they mean, how they differ, and how they impact your finances.
We’ll also briefly go over a third option—modified accrual accounting—a hybrid of the two.
Table of contents
- Choosing the right method for your business
- What is cash basis accounting?
- What is accrual accounting?
- Differences between accrual vs. cash
- Modified accrual (hybrid accounting)
- How Xendoo helps with accounting
Choosing the right method for your business
To help you decide between accrual and cash accounting—or a hybrid of the two, you can use the comparison table below.
|Simplest accounting method||Flexible accounting method||Most complex accounting method|
|Best for service-based businesses||Best for companies that carry some inventory||Best for companies that carry a lot of inventory|
|Small businesses||Growing businesses||Large and public companies|
Some business owners start out using cash basis accounting, then switch to hybrid or accrual accounting. You can always switch later, but you may want an accountant to help you transition. We’ll go into each method in more detail below to help you decide.
What is cash basis accounting?
Cash basis accounting, the simpler of the two accounting methods, records transactions when cash changes hands. In other words, you report income when you receive cash and record expenses when you pay your bills.
Since you only record transactions when you receive money, cash basis accounting doesn’t include accounts payable and receivable. You don’t account for sales customers made on credit (receivable) or business purchases you made on credit (payable).
Benefits of cash basis
The cash basis accounting method is a popular choice for small business owners because it’s simple. Here are other benefits of cash accounting:
- It’s a straightforward approach that gives you tax-ready finances.
- Managing taxes and cash flow can be easier because you pay taxes when you receive money, not when you send invoices.
Limitations of cash basis
- It’s not as accurate as accrual accounting
- It may not provide meaningful insight into your profitability.
- Some businesses can’t use cash basis accounting because it doesn’t meet Generally Accepted Accounting Principles (GAAP).
Cash accounting example
Let’s look at an example to help you understand the cash accounting method.
Say your company sells a product to a customer in December 2022, but you don’t receive payment until January 2023.
Even though you sold the product in December of 2022, you’ll record the transaction as a sale in January 2023, when you receive payment. That “sale” becomes part of 2023 for tax and reporting purposes, even though you technically made the sale in 2022.
What is accrual accounting?
In accrual accounting, you record income (sales) and expenses when the transaction occurs, regardless of when the payment happens.
Simply put, you record every transaction twice through debits and credits. This gives you a more accurate picture of your gross profit and your net income.
Admittedly, accrual accounting is more complex and requires more time than cash basis accounting. However, it gives you a clear view of your profitability to help you make informed business decisions. Often, if you’re looking to exit or sell your company, you must use accrual accounting.
Benefits of accrual accounting
Many companies choose the accrual accounting method because it’s more accurate than the cash basis method. Here are the main benefits of accrual accounting:
- It gives you a thorough and accurate record of your company’s profitability and financial health.
- Accrual accounting follows GAAP, and publicly traded companies must use it.
- It’s easier to do financial projections and reporting like cash flow statements.
Downsides of accrual accounting
- It requires more detailed record-keeping and can be difficult if you don’t have accounting experience.
- It’s a more time-consuming method because you need to match up the numbers within set time periods.
- With accrual, you pay tax on all your business’ sales, regardless of whether you’ve actually received the money for the transaction yet.
Because it’s more complex, many businesses use online bookkeeping and accounting services to handle accrual accounting for their business.
Let’s use the example from earlier but record it with accrual accounting.
Your company sells a product to a customer in December of 2022, but you don’t receive payment until January 2023.
Using the accrual method, you’ll record the sales transaction as revenue in December. You’ll also include the transaction when you file your 2022 business income tax return.
Additionally, you would ensure the cost of the product (COGS), regardless of when you pay for it, is also included in December. This provides accurate gross profit to better understand your pricing’s efficiency.
Differences between accrual vs. cash basis
We’ve talked about some of the top differences between cash and accrual accounting. The comparison chart below recaps what we’ve highlighted so far.
|Records transactions when you receive money or when you pay money (expenses)||Records transactions when they happen, regardless of when you receive or make payments|
|Does not include accounts payable and receivable||Uses accounts payable and receivable|
|Is simple, but not as accurate||Is complicated, but more accurate|
|Cash flow is simpler to track||Cash flow may need more adjustments|
|Taxes are due on the money you receive during the tax period||Taxes are due when you earn income during the tax period|
Modified accrual (hybrid accounting)
Modified accrual accounting is a hybrid method that combines parts of cash basis and accrual accounting. Because it combines the two, you can customize it based on your business needs.
For example, some companies record short-term transactions using the cash method but record long term-transactions using the accrual method.
Benefits of modified
- It gives businesses a clear picture of their financial health.
- You can tailor the modified method to fit your business needs.
- Compared to full accrual accounting, it’s easier to do.
Downsides of modified
- It’s more complex than cash and requires more effort to implement and maintain.
- It focuses more on short-term cash flow, so you may not get the full picture of your long-term financial health.
Modified accrual example
Let’s use a business that sells goods and services as an example of how modified accrual accounting works.
Under modified accrual accounting, the business would record a sale when they receive payment from the customer, regardless of when the customer placed their order.
On the other hand, they would record expenses (like purchasing inventory) as soon as they place their order, even if their payment isn’t due until later.
How Xendoo helps with accounting
Understandably, choosing between cash, accrual, or hybrid accounting can be challenging. Although choosing the method to record your business finances is an important decision for your financial health, it’s not the most exciting one.
Many entrepreneurs partner with online accounting services like Xendoo to handle their business finances. With Xendoo, your bookkeeping, accounting, and taxes are all under one roof. Plus, we’re familiar with cash, accrual, and modified accrual accounting.
If you’re unsure which accounting method is right for your business, reach out to schedule a call. Our accounting experts will get to know your business and identify which services you need, including the accounting method.