In accounting, there are two primary methods—accrual and cash basis. The main difference between accrual vs. cash basis accounting is in how and when you record income and expenses in your books. Each accounting method has advantages and disadvantages, so it is important to understand their differences before choosing which to use for your business.
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.
Table of contents
- What Is Cash Basis Accounting?
- What Is Accrual Accounting?
- Differences Between Accrual vs. Cash Basis
- Choosing the Right Method for Your Business
What Is Cash Basis Accounting?
Cash basis accounting is the simpler of the two accounting methods. In cash basis accounting, transactions are recorded as cash changes hands. In other words, income is reported when cash is received, and expenses are recorded when you pay your bills.
Because it only records transactions when money is received, the cash basis method does not include accounts payable and receivable. In other words, you don’t account for sales customers made on credit (receivable) or business purchases you made on credit (payable).
Benefits of Cash Basis
- The major benefit of cash basis accounting is that it is simple. It can be done as easily as balancing your personal checkbook, so it doesn’t require any specialized accounting techniques.
- It can make it easy to identify when transactions occur since these will be recorded on your bank statements too.
Limitations of Cash Basis
- Cash basis may be simple, but it is not as accurate as accrual accounting.
- It only provides a day-by-day look at your finances, so it is more difficult to plan ahead.
What Is Accrual Accounting?
In accrual accounting, income and expenses are recorded when they occur, regardless of when money actually changes hands. In fact, it’s not uncommon to record income before you receive payment or to record future expenses before they occur.
Admittedly, this method is slightly more complex than cash basis accounting, but it is the standard for most businesses for a reason.
Benefits of Accrual Accounting
- It provides a thorough record of your company’s revenue and liabilities.
- Larger companies rely on accrual accounting because it gives them a better, more accurate picture of their financial health.
Downsides of Accrual Accounting
- Accrual is more complicated than cash basis. You have to know the right accounting practices and standards to do it properly.
Differences Between Accrual vs. Cash Basis
We’ve talked about some of the top differences between accrual vs cash basis. The comparison chart below recaps what we’ve highlighted so far.
|Records transactions when money is received||Records transactions when they happen, regardless of if payment is received|
|Does not include accounts payable and receivable||Uses accounts payable and receivable|
|Is simple, but not as accurate||Is a little complicated, but more accurate|
However, the differences between cash basis accounting vs. accrual accounting can be particularly noticeable when it comes to two things.
- Paying your taxes
- Analyzing your cash flow
Let’s take a closer look at how your accounting method will impact taxes and cash flow.
The Effect on Taxes
Basically, you’ll pay tax on every source of income, though each method records income slightly differently.
Taxes and Cash Basis
Cash basis accounting remains the most straightforward method. Income is recorded only when you receive payment, which means that you’ll pay taxes on the cash your business receives.
Cash Basis Example
For example, if your company sells a product to a customer in December of 2021 and receives payment in January 2022, this transaction would not be recorded on your business income tax return until the following year.
In other words, with cash basis accounting, your company will only pay tax on the cash you receive, rather than on future transactions.
Taxes and Accrual
When it comes to taxes, accrual accounting can be a bit tricky. With accrual accounting, you record income and expenses as they occur, rather than when you actually receive payment. This means that you’ll pay tax on all business income, regardless of whether you’ve actually received the money for the transaction yet.
Accrual Basis Example
Returning to our above example, if you sell a product to a customer in December of 2021 but don’t receive payment until January 2022, you would still pay income tax on that sale. Even though payment was not rendered during the same tax year, it is considered income according to the accrual accounting method.
Understandably, this is why it’s important for companies to manage their finances appropriately to prepare for taxes. One of the ways business owners keep a handle on their tax planning is by choosing to outsource bookkeeping and accounting tasks.
Online accounting firms like Xendoo can provide preparation and guidance to ensure you hold back enough money to cover your tax payments.
The Effect on Cash Flow
When comparing cash basis accounting vs. accrual accounting, it’s important to understand how each method can impact your cash flow—the movement of money in your business.
Consider the following example, and then look at how each accounting method would calculate cash flow. Let’s assume you:
- Sent a client an invoice for $500
- Received a bill for $100 for the month
- Paid $20 in fees for a bill you received the previous month
- Received $100 from a client for an invoice sent the previous month
Pay attention to when money actually changes hands in our above example. This will greatly impact how cash basis accounting and accrual accounting will record cash flow.
Cash Basis Accounting and Cash Flow
Cash basis accounting will look at the example above and focus on the money that is changing hands.
In our example, the only actual transactions that are recorded are the $20 you paid in fees and the $100 you received from your client, meaning your total profit is $80.
But do you see the danger of this method? Cash basis accounting records cash flow as $80.
With this method, when you look at your upcoming expenses, you’ll have a bill in the amount of $100. You won’t be able to cover this expense until your client pays their $500 invoice.
This means that despite the simplicity of cash basis accounting, it has the potential to overstate your financial health at any given time. With that in mind, let’s take a look at how accrual accounting would handle this same example.
Accrual Accounting and Cash Flow
Unlike cash basis accounting, accrual accounting would record each transaction in the above example, regardless of when money is received.
Therefore, in our example, accrual accounting will record income in the amount of $600 ($100 received + $500 invoice), and expenses in the amount of $120 ($20 spent + $100 bill). The final profit for the month would therefore be $480 ($600 – $120 expenses).
This is a sizable difference. The same company would record profits of $80 or $480 depending on their accounting method.
In comparing accrual vs. cash basis accounting, you can see how accrual accounting provides a more comprehensive picture of a company’s revenue and liabilities but doesn’t necessarily provide an accurate picture of your actual cash on hand.
This is why cash basis accounting works best for small companies or those with simple transactions, while larger companies prefer the accrual method.
Choosing the Right Method for Your Business
Choosing between cash basis vs. accrual accounting can seem challenging, but there are some basic considerations that can help you decide.
Keep in mind that if your business earns more than $5 million in annual sales, you must use the accrual method. However, if your business earns less than $5 million, you may choose between the two methods.
When to Use Cash Basis Accounting
Cash basis accounting can be beneficial for smaller companies and startups. This can actually be a great method for eCommerce bookkeeping. If your company relies on a lot of online sales, cash basis accounting can make it easier to keep track of your books.
You should consider cash basis accounting if your business fits any of the following criteria:
- Your company is small
- You carry little inventory
- You produce products on demand
- You run a small eCommerce business (or an Amazon FBA store)
Some business owners start out using the cash basis method, then switch to the accrual accounting method after their business grows. This is perfectly legitimate, though you may need the assistance of a financial professional to help you make a frictionless transition between methods.
When to Use Accrual Accounting
Accrual accounting is the preferred method for larger businesses. It can also provide an accurate solution for businesses that do any of the following:
- Conduct high-volume business
- Maintain a lot of inventory
- Conduct larger projects with multiple phases
- Pay contractors for project milestones
Construction companies, for example, can benefit from accrual accounting. It’s easier to manage the money they receive from clients, as well as the expenses incurred from equipment and subcontractors.
Similarly, web developers can benefit from the accrual method. It is ideal for businesses that have larger, complex projects that require multiple phases to complete.
Understandably, this can be a bit intimidating for business owners who already have a lot on their plates. Many entrepreneurs partner with online accounting services like Xendoo. We can provide assistance with your accounting and bookkeeping needs.
Getting Behind? We’re Here to Help!
Hopefully, now, you’ve got a better grasp on cash basis accounting vs. accrual accounting. But what if after reading this article, you realize you’ve been doing it wrong? What if you’ve been putting your books off until “tomorrow” and you’re not sure what to do?
First, don’t panic! At Xendoo, we’ve helped countless clients get caught up and back on the right track. The online bookkeeping features offered by our skilled team can ensure that you have all the help you need to manage your books, monitor your cash flow, and prepare for tax season.
If keeping track of your books gives you anxiety, don’t wait another day. Our free, no-obligation trial can show you how your business can thrive with accurate books. Sign up today and get back to managing your business!