There’s more to accounting than keeping a record of your transactions! Accounting provides a snapshot of your business’ assets and liabilities. It also allows you to budget, plan, make important financial decisions, and assess the overall performance of your company.
Continue reading to familiarize yourself with the cash vs. accrual accounting debate and make an empowered decision that steers your business on the right path. A careful analysis of the pros and cons of both options will help you select the accounting method that best meets your company’s needs. The key difference between the two methods is the timing in which the transaction is recorded. Whichever way you choose, the accounting method you use will govern your books for a good long while—so make sure you choose wisely.
Under U.S. GAAP, the standardized reporting method is “accrual” accounting. Learn about the eight core bookkeeping jobs, from data entry to reporting and tax prep. It’s beneficial to sole proprietorships and small businesses because, most likely, it won’t require added staff (and related expenses) to use. Ultimately, this method may become more expensive or time-consuming, making it harder for small businesses to use.
Overview: What is the difference between cash and accrual accounting?
If you use the accrual bookkeeping method, you’ll want to frequently draw up accurate cash flow statements so you can make wise on-the-ground decisions about when and how to spend your (actual) money. Understanding the difference between cash and accrual accounting is important, but it’s also necessary to put this into context by looking at the direct effects of each method. If the company receives an electric bill for $1,700, under the cash method, the amount is not recorded until the company actually pays the bill. However, under the accrual method, the $1,700 is recorded as an expense the day the company receives the bill.
- And if you run a hybrid accounting system, smart software will allow you to switch between cash basis and accrual basis whenever you need.
- Any unsettled invoices or unpaid bills are not recorded until they are completed.
- The upside is that the accrual basis gives a more realistic idea of income and expenses during a period of time, therefore providing a long-term picture of the business that cash accounting can’t provide.
You may also hire someone today to take product photos for you, but you do not record that expense until you actually pay them for the work. This means you will not report any revenue on your income statement unless you have the cash in hand. You will also not have any expenses on file that you have not yet paid for. Using the example above, you deliver a shipment to a client in July and the client pays you in September. In cash-basis accounting, the revenue is recorded only in September when you receive payment from the client, even though you delivered the product in July. Small businesses often don’t want to pay monthly accounting fees for accrual basis bookkeeping.
Advantages and disadvantages of accrual accounting
Both accrual and cash basis accounting methods have their advantages and disadvantages but neither shows the full picture about a company’s financial health. Although, accrual method is the most commonly used by companies, especially publicly traded companies. Before deciding on which of these two methods of accounting is best for you, let’s first understand the differences between cash and accrual accounting.
Disadvantages of accrual basis accounting
So, if your business is a corporation (other than an S corp) with gross receipts of less than $25 million per year, you can consider cash accounting. That said, cash accounting is better suited for businesses that don’t carry inventory. Accrual accounting might be the better choice if your business handles extensive inventories. Might overstate the health of a company that is cash-rich but has large sums of accounts payables that far exceed the cash on the books and the company’s current revenue stream.
Accrual accounting, however, occurs when the revenue and expenses are incurred—which is significantly different. Cash accounting offers a picture of the business at one particular point in time. Accrual accounting offers a better picture of the financial health of the business over a period of time. Accrual-focused accounting tracks revenue as it is earned and expenses the the importance of including key personnel in your project moment they are incurred. This system makes use of accounts payable and accounts receivable to formulate an accurate, real-time picture of the financial status of your business. Unlike cash basis accounting, which provides a clear short-term vision of a company’s financial situation, accrual basis accounting gives you a more long-term view of how your company is faring.
The Downside to the Cash Method of Accounting
In other words, if you have a small stationery business that purchased paper supplies on credit in June, but didn’t actually pay the bill until July, you would record those supplies as a July expense. Our partners cannot pay us to guarantee favorable reviews of their products or services. Accounts by way of choosing the most appropriate method out of several alternative methods of accounting. As a business owner, managing the finances of your fast-growing company can be a hassle.
Additionally, whereas cash basis accounting does not conform to GAAP, accrual basis accounting does. If your focus is to know exactly how much money you have on hand at any given time, cash accounting is the best method for you. Another advantage is that you do not pay taxes on any income until you actually receive the money. If you carry a lot of inventory, however, the accrual method is the best choice. The accrual method requires you to recognize unearned revenue and prepaid expenses. So, you might ship an order out to a customer today, but you do not record it as revenue until you receive payment from that customer.
And while it’s true that accrual accounting requires more work, technology can do most of the heavy lifting for you. You can set up accounting software to read your bills and enter the numbers straight into your expenses on an accrual basis. And if you run a hybrid accounting system, smart software will allow you to switch between cash basis and accrual basis whenever you need. Cash and accrual accounting are accounting methods appropriate for different companies, industries, and situations. Cash accounting recognizes revenue and expenses when money changes hands.
In cash basis accounting, transactions are recorded when cash physically moves in or out of your business. More specifically, revenue is recognized as income when you receive payment, and expenses are recognized when money is spent. Accrual basis accounting can give you a more accurate picture of your business’s financial health because it takes your business’s unpaid expenses and your customers’ unpaid invoices into account.
Should I Use Accrual Basis Accounting?
Accounting software like Xero and QuickBooks Online let you choose your preferred accounting method during the setup process. Learn more about how cash accounting and accrual accounting work and which method may be best for you. If you sell $5,000 worth of machinery, under the cash method, that amount is not recorded in the books until the customer hands you the money or you receive the check. For investors, it’s important to understand the impact of both methods when making investment decisions.
It doesn’t account for either when the transactions that create them occur. On the other hand, accrual accounting records revenue and expenses when those transactions occur and before any money is received or paid out. The upside of cash accounting is that it provides you with an accurate picture of the cash flow of your business. You can look at the cash flow statement and see the cash at your disposal.