Companies can choose between two primary accounting methods: cash basis and accrual basis.The adage “timing is everything” captures the biggest difference between them.Cashaccounting reflects business transactions on a company’s financial statements when thecashflows into or out of the business. Accrual accounting recognizes revenue when it’searnedand expenses when they’re incurred, regardless of when money actually changes hands.Thedifference in timing ripples through the company’s income statements and balancesheet, andsubsequently affects its tax liability.
Each method has advantages and disadvantages. Notably, the cash method is morestraightforward. But only the accrual basis is accepted by Generally Accepted AccountingPrinciples (GAAP), which is a set of rules established by the Financial Accounting StandardsBoard (FASB). Depending on a company’s circ*mstances, it may be easy to choose whichmethodis the best fit.
Cash-Basis vs. Accrual-Basis Accounting: What’s the Difference?
Cash-basisaccounting is the easier of the two methods because, as its nameimplies, all bookkeeping simply follows the cash. The company records revenue when customerpayments are received. It records expenses when it makes payments to suppliers. Taxes arecalculated 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 oraccrued expenses) until the company pays for them. Cash-basis accounting is a simple way toeasily see a company’s cash status.
Example: The following example illustrates the timing and simplicity of cashaccounting for a small business. It also shows the swings in taxable income that can resultfrom using this method.
ITCHY Inc., a tree-spraying company, provides a monthly insection-prevention spraying servicefor 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 thetank 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.
| Jun-20 | Jul-20 | Aug-20 | Sep-20 | Oct-20 | Nov-20 | Dec-20 | Jan-21 | Feb-21 | Mar-21 | Apr-21 | May-21 | |
|---|---|---|---|---|---|---|---|---|---|---|---|---|
| Revenue | $1,200 | $ – | $ – | $ – | $ – | $ – | $ – | $ – | $ – | $ – | $ – | $ – |
| Expense | 50 | 50 | 50 | 50 | 50 | 50 | 50 | 50 | 50 | 50 | 50 | 50 |
| Income / (Loss) | $ 1,150 | $(50) | $(50) | $(50) | $(50) | $(50) | $(50) | $(50) | $(50) | $(50) | $(50) | $(50) |
| Taxable Income $850 | Taxable Income $(250) | |||||||||||
Accrual-basis accounting combines two important accounting principles: thematching principle and the revenue recognition principle. Under these principles, revenue isrecognized when it is earned, and expenses are reflected in the period that best matches therevenue they help create. Accrual accounting bookkeeping is uncoupled from when the moneyinvolved actually changes hands, thereby smoothing the impact of timing and yielding a moreaccurate overall picture of a business’ operations.
Example: Using the same example above, the following chart showsITCHY’sfinancial results using the accrual method.
- ITCHY evenly prorates the $1,200 cash as $100 of revenue for each of the obligated 12sprays.
- 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.
| Jun-20 | Jul-20 | Aug-20 | Sep-20 | Oct-20 | Nov-20 | Dec-20 | Jan-21 | Feb-21 | Mar-21 | Apr-21 | May-21 | |
|---|---|---|---|---|---|---|---|---|---|---|---|---|
| Revenue | $100 | $100 | $100 | $100 | $100 | $100 | $100 | $100 | $100 | $100 | $100 | $100 |
| Expense | 50 | 50 | 50 | 50 | 50 | 50 | 50 | 50 | 50 | 50 | 50 | 50 |
| Income / (Loss) | $50 | $50 | $50 | $50 | $50 | $50 | $50 | $50 | $50 | $50 | $50 | $50 |
| Taxable Income $350 | Taxable Income $250 | |||||||||||
Key Differences, Advantages and Disadvantages
The key difference between the cash and accrual methods relates to the timing of revenueandexpenses: When they’re received/paid and when they’re earned/incurred.
Many businesses prefer to use cash accounting because the financial statements closelyreflect their cash position, which is especially important for small business owners.Thesimplicity also makes bookkeeping easier and cheaper. And under cash-basis accounting abusiness 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 maylook distorted. Those distortions can make planning and forecasting complicated. Also,cashaccounting is not accepted by GAAP, and any resulting financial statements areconsideredinsufficient by most lenders and are prohibited for publicly traded companies.
The accrual basis of accounting is the gold standard because it gives a more accuraterepresentation of a company’s finances. With accrual accounting, businesses can moreeasilykeep track of credit transactions using an accounts receivable system, which shows thefulltransaction history of each customer. An accounts payable system shows the transactionhistory between your company and a vendor or supplier. GAAP compliant accrual accountingisrequired for companies of a certain size, with certain debt covenants or that arepubliclytraded.
A disadvantage of accrual accounting is the additional bookkeeping. Rather than just lookatcash coming in and out, businesses using accrual accounting monitor receivables, prepaidexpenses, accounts payable and other accrued liabilities. It also requires more frequentclosing of the company’s books. Another disadvantage is that the accrual basis mightobscureshort 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 anddisadvantages are in the chart below.
| Cash Method | Accrual Method | |
|---|---|---|
| Differences |
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| Advantages |
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| Disadvantages |
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What are Recording Transactions?
For the most accurate and useful financialstatements, accountants recordtransactions using double entry bookkeeping. Each transaction is entered in twoaccounts:debits and credits. These two entries are equal and opposite. Listing everything twicecanhelp companies catch errors and prevent fraud, and it can be beneficial for auditing.Bothcash- and accrual-basis accounting can use double entry bookkeeping. In accrualaccounting,the five types of accounts—revenue, expense, asset, liability, and equity—areused tocategorize transactions.
The single-entry system looks a little more like a personal bank account where amountsarecredited or debited in one table or ledger. It can only be used with cash-basisaccounting,not accrual accounting.
Choosing Between Cash- and Accrual-Basis Accounting
Businesses with less than $25 million in gross receipts have a choice between the twomethods, but all publicly traded companies must use accrual accounting and comply withUS GAAP for both financial reporting and tax purposes.
However, growing businesses typically shift to accrual basis accounting well before that$25 million threshold as transactions become more complex, management desires a morerealistic view of financial performance, and investors or lenders require financialstatements prepared using accrual accounting. For details on how to apply the grossreceipt test, the IRS guidelines on acceptable accounting methods and how to change youraccounting method, refer to IRS Publication 538.
Cash-basis accounting might be right for your business if you rely on cash payments forrevenue and expenses. Conversely, businesses that extend credit to customers or use creditwith their suppliers tend to find that accrual accounting gives a better picture of overallfinancial health. Businesses that hold large amounts of inventory also benefit from accrualaccounting. In general, the greater the lag in conversion to cash from sales, the strongerthe 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 cashflowandtax liabilities, as illustrated above. It can also impact the policies and processesthat abusiness needs to adopt. A few examples include:
- Companies that use the cash method of accounting won’t have accounts receivableledgersand need processes to stay on top of outstanding customer accounts.
- Companies usually use the cash method of accounting because they deal mostly withcashtransactions. They need safeguards over receipts and disbursem*nts of cash so it’snotlost or stolen.
- Companies that use the accrual method of accounting implement procedures toreconcilebank accounts and keep tabs on short term cash flow.
- Start-ups andentrepreneurs using cash accounting for simplicity often need to changetheiraccounting policies in later stages as they begin to invest in long-term assets orcontemplate initial public offerings.
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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. Andthosebenefits are especially useful for the more complex accrual method. Recurring journalentries, bank reconciliations and balancing accounts—all key components of accrualaccounting—are included in the core functionality of most accounting software.
