Companies can choose between two primary accounting methods: cash basis and accrual basis. The adage “timing is everything” captures the biggest difference between them. Cash accounting reflects business transactions on a company’s financial statements when the cash flows into or out of the business. Accrual accounting recognizes revenue when it’s earned and expenses when they’re incurred, regardless of when money actually changes hands. The difference in timing ripples through the company’s income statements and balance sheet, and subsequently affects its tax liability.
Each method has advantages and disadvantages. Notably, the cash method is more straightforward. But only the accrual basis is accepted by Generally Accepted Accounting Principles (GAAP), which is a set of rules established by the Financial Accounting Standards Board (FASB). Depending on a company’s circumstances, it may be easy to choose which method is the best fit.
Cash-Basis vs. Accrual-Basis Accounting: What’s the Difference?
Cash-basis accounting is the easier of the two methods because, as its name implies, all bookkeeping simply follows the cash. The company records revenue when customer payments are received. It records expenses when it makes payments to suppliers. Taxes are calculated on the resulting net income.
Under the cash basis, there is no need to account for customer sales made on credit (i.e. accounts receivable) until they pay. Similarly, no bookkeeping is required for purchases from vendors on credit (i.e. accounts payable or accrued expenses) until the company pays for them. Cash-basis accounting is a simple way to easily see a company’s cash status.
Example: The following example illustrates the timing and simplicity of cash accounting for a small business. It also shows the swings in taxable income that can result from using this method.
ITCHY Inc., a tree-spraying company, provides a monthly insection-prevention spraying service for its customers. A customer signs an annual contract and pays $1,200 upfront on June 1, 2020. ITCHY pays its chemical supplier $50 for each tank of insecticide when it picks up the tank on the morning of each monthly spray.
- ITCHY records all $1,200 of revenue in June.
- ITCHY records $50 in expenses in each month, June-May.
- ITCHY’s income/(loss) for each of the 12 months is shown below.
- ITCHY pays income taxes on $850 of income for 2020 and shows a loss for 2021.
Accrual-basis accounting combines two important accounting principles: the matching principle and the revenue recognition principle. Under these principles, revenue is recognized when it is earned, and expenses are reflected in the period that best matches the revenue they help create. Accrual accounting bookkeeping is uncoupled from when the money involved actually changes hands, thereby smoothing the impact of timing and yielding a more accurate overall picture of a business’ operations.
Example: Using the same example above, the following chart shows ITCHY’s financial results using the accrual method.
- ITCHY evenly prorates the $1,200 cash as $100 of revenue for each of the obligated 12 sprays.
- ITCHY records $50 in expenses in each month, June-May.
- ITCHY’s income/(loss) is shown for each of the 12 months.
- ITCHY pays income taxes on $350 of income for 2020 and $250 for 2021.
Key Differences, Advantages and Disadvantages
The key difference between the cash and accrual methods relates to the timing of revenue and expenses: When they’re received/paid and when they’re earned/incurred.
Many businesses prefer to use cash accounting because the financial statements closely reflect their cash position, which is especially important for small business owners. The simplicity also makes bookkeeping easier and cheaper. And under cash-basis accounting a business doesn’t have to pay taxes on cash it hasn’t collected.
The main disadvantage of the cash basis is that financial results in any given period may look distorted. Those distortions can make planning and forecasting complicated. Also, cash accounting is not accepted by GAAP, and any resulting financial statements are considered insufficient by most lenders and are prohibited for publicly traded companies.
The accrual basis of accounting is the gold standard because it gives a more accurate representation of a company’s finances. With accrual accounting, businesses can more easily keep track of credit transactions using an accounts receivable system, which shows the full transaction history of each customer. An accounts payable system shows the transaction history between your company and a vendor or supplier. GAAP compliant accrual accounting is required for companies of a certain size, with certain debt covenants or that are publicly traded.
A disadvantage of accrual accounting is the additional bookkeeping. Rather than just look at cash coming in and out, businesses using accrual accounting monitor receivables, prepaid expenses, accounts payable and other accrued liabilities. It also requires more frequent closing of the company’s books. Another disadvantage is that the accrual basis might obscure short term cash flow issues in a company that looks profitable on paper.
A summary of key differences between the two methods, as well as their advantages and disadvantages are in the chart below.
What are Recording Transactions?
For the most accurate and useful financial statements, accountants record transactions using double entry bookkeeping. Each transaction is entered in two accounts: debits and credits. These two entries are equal and opposite. Listing everything twice can help companies catch errors and prevent fraud, and it can be beneficial for auditing. Both cash- and accrual-basis accounting can use double entry bookkeeping. In accrual accounting, the five types of accounts—revenue, expense, asset, liability, and equity—are used to categorize transactions.
The single-entry system looks a little more like a personal bank account where amounts are credited or debited in one table or ledger. It can only be used with cash-basis accounting, not accrual accounting.
Choosing Between Cash- and Accrual-Basis Accounting
For all publicly traded companies and most businesses with investors or lenders, there is no choice in accounting method. These companies must comply with GAAP and use the accrual basis of accounting for both financial reporting and tax purposes.
Businesses with less than $25 million in gross receipts do have a choice. For details on how to apply the gross receipt test, the IRS guidelines on acceptable accounting methods and how to change your accounting method, refer to IRS Publication 538.
Cash-basis accounting might be right for your business if you rely on cash payments for revenue and expenses. Conversely, businesses that extend credit to customers or use credit with their suppliers tend to find that accrual accounting gives a better picture of overall financial health. Businesses that hold large amounts of inventory also benefit from accrual accounting. In general, the greater the lag in conversion to cash from sales, the stronger the argument for accrual-based accounting.
Effects of Cash and Accrual Accounting on Cash Flow, Taxes and Policy
The method of accounting, cash or accrual, can significantly impact a company’s cash flow and tax liabilities, as illustrated above. It can also impact the policies and processes that a business needs to adopt. A few examples include:
- Companies that use the cash method of accounting won’t have accounts receivable ledgers and need processes to stay on top of outstanding customer accounts.
- Companies usually use the cash method of accounting because they deal mostly with cash transactions. They need safeguards over receipts and disbursements of cash so it’s not lost or stolen.
- Companies that use the accrual method of accounting implement procedures to reconcile bank accounts and keep tabs on short term cash flow.
- Start-ups and entrepreneurs using cash accounting for simplicity often need to change their accounting policies in later stages as they begin to invest in long-term assets or contemplate initial public offerings.
Using Accounting Software to Streamline Your Accounting Process Practice
Accounting software can automate functions, make workflows and processes more efficient, reduce errors and lower staff costs with both cash- and accrual-basis accounting. And those benefits are especially useful for the more complex accrual method. Recurring journal entries, bank reconciliations and balancing accounts—all key components of accrual accounting—are included in the core functionality of most accounting software.