Cash accounting and accrual accounting differ in the way they track income and expenses, as well as the types of businesses for which they tend to work best. Small businesses may prefer cash accounting because it is easy to implement and maintain. But larger or more complicated businesses need the more holistic financial picture that can be obtained from accrual accounting.
With cash and accrual accounting, accounting software like QuickBooks Online can automate workflows and minimize errors. But if you manage your accounting manually, it can be difficult to know how to use these methods to manage your finances, so let's get into it.
What is cash accounting?
Cash basis is a fairly simple way to track your business's income and expenses. With cash accounting, you will record income and expenses when you actually receive or issue payments. It does not track or record revenue you have not yet received or costs you have not yet paid.
How does cash accounting work?
With cash accounting, if your business provided a service but is still awaiting payment, that revenue is not yet represented in your records. If you issue an invoice in July with a due date in August, you won't record revenue for that invoice until you receive actual payment in August.
Similarly, if you have incurred an expense but have not yet paid it, cash accounting dictates that you do not record the expense until you have issued your payment and the money has left your account.
Why would a company use cash accounting?
Some companies use cash accounting because it is relatively easy to implement. Because you don't need to track many ongoing expenses or income streams, cash accounting is a simple way to keep track of your finances and cash flow.
But keep in mind that cash accounting will be less accurate than other types of accounting, including accrual accounting.
What is accrual accounting?
Accrual accounting represents a more holistic view of your company's finances than you would get with cash accounting. Account for income and expenses as soon as they are incurred.
How does accrual accounting work?
With accrual accounting, you will record sales revenue and expense payments as they occur, regardless of whether money has changed hands or not. If you bought a bunch of inventory tomorrow, you'll record that expense as soon as the order is placed, even if you haven't paid the invoice yet.
Similarly, if you perform a service for which you are owed money, you will record income from that service as soon as it is completed, rather than waiting until you are paid.
Why would a company use accrual accounting?
Because accrual accounting takes into account all expenses and all income as soon as each incident occurs, it provides a more accurate picture of your company's financial health than cash-based accounting systems. The accrual basis will tell you not only how much money you currently have accounted for, but also what your finances will look like after any outstanding payments and costs are settled.
But while accuracy is a good reason to opt for accrual accounting, it is also more complicated to implement than a cash-based accounting system. Accrual accounting must comply with GAAP (Generally Accepted Accounting Principles) and can be complicated to track.
What is the difference between cash and accrual accounting?
The main differences between cash accounting and accrual accounting include:
- Timing of expense tracking.
- Compliance with the correspondence principle.
- Difficulty of implementation.
- GAAP Compliance.
While accrual accounting tracks expenses as soon as they occur, cash accounting delays recording them until money has actually changed hands. That makes accrual accounting more complicated to maintain, as you have to track accounts payable and accounts receivable to make sure your records match your payment activity.
While cash accounting is easier to implement and maintain, accrual accounting gives you a more accurate picture of your business's overall finances. Because accrual accounting includes both payments and costs you've incurred now and in the future, you can get a better idea of cash flow.
The cash basis also does not follow the matching principle, which is the concept of matching income to related expenses during the period in which they were incurred. Matching expenses to when they occurred allows you to calculate net income for a given time period.
Cash vs. Accrual Accounting Examples
Let's take a look at how cash accounting compares to accrual accounting with a simple example:
If your business provides services in December, invoices the customer in January, and receives payment in February, then the time between when a service was provided and when you were actually paid spans the course of three months.
If you use cash accounting In this scenario, you would then not record revenue from your services until February, when the payment is actually received and posted to your account.
If you use the accrual In this example, you would record service revenue in December, when the service was provided. That gives you a more accurate financial picture of where your business is financially because you know you're owed a certain amount of revenue, even though you won't actually receive the money for a couple more months.
Which to choose: cash accounting or accrual accounting
The accounting system you choose will depend on the size of your business and how accurate you want your financial records to be.
We recommend cash accounting for:
- Small businesses or self-employed.
- Companies with minimal accounts receivable and payable.
- Companies without inventory.
- Secondary scammers.
We recommend accounting on an accrual basis:
- Large companies or corporations with complex accounts receivable.
- Companies that carry inventory.
- Businesses with high startup costs or substantial upfront payments.
- Companies in highly regulated industries.
- Businesses that require external audits or reports.
Of course, the best method for your business is up to you and you may need to try both to see which best suits your operations.
However, you can also ease your accounting burden by getting free accounting software for easier management, regardless of which method you choose.
