What’s the Difference Between Cash Basis and Accrual Basis?
Understand how accrual accounting impacts your business and when to use it.
- Cash basis is much simpler and more straightforward than accrual accounting.
- Businesses incur revenue and expenses at different times based on which type they use.
- Accrual accounting is required for many businesses.
- This article is for entrepreneurs and professionals interested in accounting software and practices.
Businesses can only report income and costs using the cash basis when real payments or receipts of cash are made. Instead of recording when money actually changes hands, accrual accounting tracks revenue and costs as they are incurred (when an invoice is made or a bill is received). Although accrual accounting is desirable for some organizations and essential for others to take advantage of specific tax techniques, cash accounting is significantly easier to use.
Due to the distinctions between cash and accrual accounting, one approach can be better suited to your company’s needs than the other. Fortunately, most accounting software makes it simple to monitor the financial health of your company using both cash basis and accrual approaches. But keep in mind that no matter which approach you choose, you must document your income and spending consistently.
Cash vs. accrual accounting
The primary distinction between cash and accrual accounting is the timing of when revenue and costs are recorded in a company’s books. Cash accounting is nearly always preferred by businesses that can utilize it since it is easier to understand.
When a firm incurs tax obligation (or benefit) as a result of these activities depends on whether it uses cash accounting or accrual accounting because revenue and costs are recorded at various periods depending on which method is used.
Businesses that use accrual accounting, as opposed to those that use cash accounting, are subject to taxation on all sales made within a given year, whether or not the sales have been paid for.
Pros and cons of cash basis accounting
With cash basis accounting, revenue is reported as soon as it is really received, and costs are reported as soon as they are paid. Accounts payable and receivable are not recognized or tracked in cash accounting. Because of this, the technique works well for small enterprises without goods on hand.
It lets you see cash on hand.
Cash accounting makes it easy to see how much money your business actually has at any given time and provides a snapshot of actual account balances.
It offers more control over transactions.
This can result in more reliable cash management and tax advantages.
It’s easier to track income and expenses.
Just track when you get money or when it leaves your account. You don’t have to track receivables or payables (though you still should).
There’s less risk of not affording tax payments.
Income isn’t taxed until it’s actually in your account.
It doesn’t show a business’s liabilities.
Cash basis accounting makes it difficult to see your business’s liabilities because it doesn’t reflect future payables.
It’s not appropriate for all businesses.
The IRS does not allow companies that make sales on credit or have collected $26 million in gross sales in any one of the past three years to use cash accounting.
It’s difficult to transition to accrual accounting.
If you start out using cash accounting, it can be difficult to transition to accrual accounting later, which can lead to mismanagement of company finances.
Pros and cons of accrual basis accounting
When using the accrual foundation of accounting, revenues and costs are recorded when they are incurred rather than when the money is brought in or spent. The most popular accounting system, known as accrual basis, is required for businesses with gross receipts of at least $26 million during the previous three years. For companies with average annual gross sales of more than $25 million over the previous three years, accrual accounting is also necessary. Learn how to create an income statement in this linked post.
It makes it easy to see future revenue and expenses.
Accrual basis accounting, as opposed to cash accounting, gives you a complete picture of your company’s financial situation. This is due to the fact that you track payables and receivables in addition to merely the money that has been placed into or taken out of your accounts.
It provides a more accurate picture than cash basis accounting.
Receivables and payables are a part of accrual accounting, which offers a more complete picture of a company’s financial position.
It allows tax savings for depreciation.
While companies that utilize accrual accounting have an early tax responsibility for sales, they may also be able to benefit from depreciation (of certain assets) to reduce their long-term tax burden.
It has extensive rules and regulations.
Compared to cash accounting, accrual accounting is more complex and has rules that apply to certain kinds of transactions. Even which firms must utilize accrual accounting are subject to regulations.
It requires more work than cash accounting.
You’ll probably need to engage a specialist accountant if your business would profit from accrual accounting (or if you’re obliged to use it) but you don’t have the time to manage the books yourself.
It doesn’t reflect money that’s actually available.
You might not have as much cash on hand as your records indicate since accrual accounting bases account balances on transactions that may not have settled yet.
It may require you to pay taxes on income you haven’t yet received.
Even if the money from the sale isn’t received for many weeks or months, sales you make near the end of the year will still be subject to taxation in the year the sale was made.
Example of how cash and accrual affect the bottom line
Take, for example, a small retail business that completes the following transactions in one month:
- Purchases inventory for $5,000
- Pays $300 in utilities
- Receives a $500 bill for building maintenance
- Makes $8,000 in sales
- Sends a $2,000 invoice for a custom order it fulfilled
The company made a $2,700 profit for the month using the cash foundation of accounting. Due to the fact that the $500 maintenance charge and $2,000 invoice have not yet been paid or received, they are not included in the month’s accounting. The company’s records, on the other hand, will show a profit of $4,200 for the month if it utilizes accrual accounting since all of the revenue and outgoing costs that were tallied during that period are included. Learn how to calculate profit margins in this linked post.
How to choose the right method for your business
The ideal accounting procedure for your company depends on a number of variables. Generally speaking, small enterprises and companies that don’t use inventory as part of their operations should use cash accounting. Large companies and firms that use inventories should instead choose accrual basis accounting. In order to be ready for future accounting requirements, small firms that are anticipated to develop may also wish to start using accrual basis accounting.
You might not have a choice, depending on the kind of business you run, how much money you make, and the kinds of sales you make. Certain firms must utilize accrual basis accounting, according to the IRS.
For instance, businesses that aren’t S-corps must utilize accrual basis accounting if their average gross revenues for the previous three years were over $25 million. Cash accounting is also illegal for some businesses and tax havens, including those that do credit sales.
The majority of the best accounting software systems make it simple to pick between cash and accrual accounting for your company; some even offer advice on which will be more advantageous for you.