Mar 19, 2021Cash vs. Accrual: What’s the Difference?
As a small business owner, keeping an accurate record of revenue and expenses is a vital part of making decisions, allocating resources, and planning for the future. One essential decision to make upfront is which accounting method to use: cash or accrual.
In this article, we’ll explain the difference between the two methods, how each method impacts reporting, and the underlying costs associated with each.
What is Cash Accounting?
The cash basis of accounting recognizes revenue and expenses as they are received and paid. Any time cash flows in or out of your account, it’s recorded. This method does not utilize accounts receivable or accounts payable, meaning that outstanding services due or expected payments aren’t tracked.
For example, if a business owner signs a year-long contract to receive office supplies from a local supplier, the cash amount of the payment will immediately show up on the books, even if the office supplies haven’t been delivered.
The cash method is beneficial because it gives a current snapshot of disposable resources. It’s also relatively simple and inexpensive to maintain, making it a popular choice for small businesses.
What is Accrual Accounting?
Accrual accounting is a method of accounting where expenses and revenues are recorded in the month they are recognized, not necessarily when cash changes hands.
This method utilizes accounts receivables and accounts payables, which are accounts that represent instances in which the company has earned money or owes products or services to another company.
For example, let’s say a lawn mowing company sells a summer’s worth of service to an individual, who pays the entire sum up front. Instead of recording the entire cash amount on the books in the month the lawn company was paid, the income would be recorded each time a lawn was mowed.
The upside to the accrual method is that it gives a more realistic picture of where the company is at financially. This gives a broader perspective of company standing and can help leaders make more informed decisions.
The downside is it’s expensive.
Why is there a cost difference?
No doubt cash and accrual have significantly different price tags. Accrual generally costs more because it requires higher level technology to track revenue and expenses as they are realized. This also requires a higher level of accounting knowledge, since it utilizes more accounts.
Cash accounting is less expensive, because it simply tracks the flow of cash. The technology is not much different than tracking your income and expenses on a personal bank statement.
Why would someone choose accrual if it’s more expensive?
It might be required
Some companies are required to use the accrual accounting method for tax compliance:
- Companies with inventories or goods
- C corporations
- Companies that have more than $26 million in revenue*
- Publicly traded companies
*If your company has less than an average annual gross receipt of $26 million, you are allowed to choose between cash and accrual. Companies earning more than $26 million are restricted to the accrual method, since this method conforms with GAAP. Prior to 2020, only companies earning $5 million or less could opt to use the cash method.
Better for external stakeholders
In cases where there are external stakeholders that need to be privy to your financial information (think investors, shareholders, and advisors), you may want to utilize the accrual accounting method. The accrual method more accurately portrays the relationship between work to be done, cash received, and income to be earned. When making critical financial decisions, these large amounts of revenue and expenses that haven’t been realized yet may be critical to have on hand.
Better for getting a current financial picture
Although this method requires more prompt and intensive bookkeeping, it does give business owners a more realistic snapshot of current company health. This can provide owners, accountants, and investors with the information needed to make prompt decisions and adjust strategy quickly.
Which one should I use?
It depends. Consider factors such as cost, the main consumers of the financial statements, time required for each method, and potential company growth.
At Nimbl, we recommend meeting with a trusted accountant to gain more insight into which accounting method is right for you. Although the accrual method is more expensive, it may provide the adequate insights needed for your evolving business. However, the cash method is more economical, potentially providing savings that can be funneled back into key initiatives. Either way, speaking with a CPA or tax professional will give you the resources and perspective needed to make a wise decision.