When deciding how to report income and expenses, business owners may choose from two accounting methods: cash basis accounting and accrual accounting. Along with impacting how a business maintains its records, the different approaches provide varying perspectives on the company’s financial performance.
As its name suggests, cash basis accounting tends to provide a clear picture of a company’s cash reserves. It’s also relatively straightforward to learn.
However, because cash basis accounting doesn’t show incoming payments or commitments coming due, it can provide an incomplete picture of a company’s health. For instance, it wouldn’t show upcoming lease payments or revenue expected from orders that are booked but haven’t shipped. Also, because cash basis accounting doesn’t match expenses with the revenue related to them, it can present a misleading picture of a company’s performance. A company’s performance can appear to fluctuate more under cash basis accounting than it does under accrual accounting, as the timing of the income and expenses recorded depend, at least in part, on when companies and their customers issue invoices or pay their bills.
In contrast, accrual accounting tends to present a “smoother” picture of revenue and expenses because it records them as they’re earned or incurred. For instance, under an accrual accounting approach, a business records its payroll expense as employees work, rather than when it issues paychecks.
Accrual accounting can provide a more encompassing picture of a company’s profitability. It shows revenue when the company delivers products or services to a customer, under the expectation payment will be received. On the—hopefully rare—occasion when payment is not received, accrual accounting allows for bad debts.
What Is Cash Basis Accounting?
Businesses using cash basis accounting record revenue when it’s actually received—say, when a check is deposited, clears and cash lands in the account—and expenses when a payment is issued.
These dates can differ from the dates on which the business actually delivers its services or incurs an expense.
Who Uses Cash Basis Accounting?
Many self-employed professionals and small-business owners use cash basis accounting. The reason? It’s generally the simplest accounting method. Cash basis accounting also provides a quick look at the amount of money the business actually has on hand. That’s a crucial metric for any company.
While many smaller, younger companies can use cash basis accounting, it’s not suitable for all. Most smaller companies that carry inventory will need to use accrual accounting, as it will enable them to track changes in inventory. Most businesses that offer their services on credit also will need to use accrual accounting.
History of Cash Basis and Accrual Accounting
For as long as people have conducted business, they’ve likely tried to record their income and expenses. Researchers have found evidence of accounting records from thousands of years ago in Mesopotamia.
In the 15th century, Luca Pacioli, a Franciscan friar and mathematician, wrote about a record-keeping system used by Venetian merchants. Pacioli’s writing helped lay the foundation for what we now know as accrual accounting.
In the intervening centuries, businesses grew and became more sophisticated. And, thus, the discipline of accounting followed in suit. During the Industrial Revolution—roughly the 18th and 19th centuries—accounting gained importance as more businesses sought outside investors. Before putting their money into a firm, many investors, not surprisingly, wanted some assurance they’d achieve a return. During this time, in 1887, the forerunner to the American Institute of Certified Public Accountants (AICPA) launched.
To be sure, problems still arose. The U.S. Securities and Exchange Commission was created in the 1930s to curb stock market manipulation and fraud. U.S. Generally accepted accounting principles (GAAP) were developed at least partly due to the 1929 stock market crash and following the Great Depression.
Even with these changes, no accounting method can completely prevent all companies from falsifying their financial records. However, organizations that engage in accounting tricks can face significant penalties. For instance, when regulators found energy giant Enron had been involved in accounting shenanigans like over-valuing assets, the company went bankrupt and more than 20 employees were convicted of crimes.
More recently, software solutions have helped to automate many bookkeeping and accounting functions. These have afforded business owners and accountants a greater ability to review and analyze transactions.
What Is Accrual Accounting?
In accrual accounting, revenue and expenses are recorded when they’re earned or incurred, even if no money changes hands at that point. With double-entry bookkeeping, required by U.S. GAAP, all transactions are recorded twice, both as debits and credits. Debit entries increase expenses but reduce revenue, while credit entries do the opposite, decreasing expenses and increasing revenue. The total of the debit and credit entries offset each other.
Using the example above, the house-painting company would record the sale when the painter completed the job, even though no money changed hands. Similarly, the business owner would record the electric bill when it was incurred.
Key Differences Between Cash Basis Accounting and Accrual Basis Accounting
Cash basis accounting is generally more straightforward and easier to administer, leaving more time for simply running the business. For a small company or startup, cash basis accounting often suffices.
As businesses grow and become more complex, accrual accounting often becomes more appropriate. It allows for recording revenue and expenses in the periods in which they’re incurred, even if no money changes hands at that point. It also allows for the tracking of inventory, as well as accounts receivable and payable. As a result, it can provide a more accurate picture of the financial health of the company.
On the downside, the accrual method is usually more time-consuming and more difficult to understand than cash basis accounting. It also can be more challenging to determine the amount of cash the business has on hand.
Choosing Between Cash Basis and Accrual Accounting
While a business doesn’t need to obtain approval from the Internal Revenue Service when initially choosing an accounting technique, it will if it decides to change methods. This notification is done by filing Form 3115, Application for Change in Accounting Method, with the IRS.
And, if a business uses the cash method for revenue, it also needs to use it for expenses.
Several additional factors can come into play when deciding between cash and accrual basis accounting:
- Because a business using cash basis accounting doesn’t record income until it receives cash, it’s less likely to have to pay income tax on sales for which it hasn’t yet received payment. At year-end, it may be able to accelerate some expenses, thus decreasing its net income and lowering the taxes it will owe.
- Public companies in the U.S. must follow generally accepted accounting principles (GAAP), which require the accrual accounting method.
- Many lenders and investors require the companies with which they do business to use the accounting accrual method. Even if a business isn’t currently seeking outside funding, if it expects to do so within the next few years, it may make sense to use accrual-based accounting from the start.
- Similarly, some business buyers require audited financial statements, and audits performed under U.S. GAAP require accrual accounting. Business owners who plan to sell their businesses within a few years will probably want to begin using accrual accounting if they haven’t already.
The most important factor in deciding which accounting method to choose is simply: What best fits your business?
Examples of Cash Basis Accounting
Consider a house-painting service that completes a project and submits an invoice in April and receives a credit card payment into its business account from the homeowner in May. Under the cash basis accounting method, the firm records the income when payment is received, even though that occurs several weeks after the job was completed. There’s a gap between the time at which the “economic event” occurred and was recorded.
Conversely, say the house painter receives a $175 electric bill covering the month of April and pays it in May. With the cash method of accounting, that $175 is recorded as a May expense even though it covered services provided in April.
Pros and Cons of Cash Basis Accounting
The two methods of accounting appeal to different businesses for different reasons.
Advantages of Cash Basis Accounting
The simplicity of cash basis accounting is appealing to many small-business owners. It’s a relatively easy method to train finance personnel to use and doesn’t require as much bookkeeping to maintain as accrual accounting yet provides enough information that many small businesses can reasonably track their performance. And because it doesn’t consider future revenue and payments, it gives a solid view of the company’s cash at the moment.
Disadvantages of Cash Basis Accounting
On the other hand, because cash basis accounting doesn’t match expenses with the revenue they help generate, it can provide an inaccurate picture of the performance of the business. Say a company purchases $500 worth of T-shirts in August and sells them for $700 in September. Under cash basis accounting (and assuming no other revenues or expenses), it would show a loss of $500 in August and a profit of $700 in September. Neither number, on its own, truly reflects the business’ performance.
The accrual basis of accounting, because it includes accounts payable and receivable, may more accurately show the company’s performance. This means it can offer a better foundation for long-term planning.
Some lenders require their business clients to use accrual accounting. These businesses generally include:
- Corporations (other than S corporations) with average annual gross receipts for the three preceding tax years exceeding $25 million, indexed for inflation.
- Partnerships that have a corporation (other than an S corporation) as one of their partners, and average annual gross receipts for the three preceding tax years exceeding $25 million (indexed for inflation).
- Tax shelters.
How Accounting Software Can Help With Cash Based Accounting
Accounting software can help any business accurately employ either a cash-based or accrual-based accounting system. The software can streamline accounting processes and help ensure accuracy and compliance with regulations. To learn more about NetSuite accounting solutions, schedule a free consultation today.