Cash basis accounting versus accrual accounting
Cash basis accounting identifies revenue when it’s received and expenses when they’re paid. It does not recognise accounts receivable or accounts payable. Many small businesses use cash basis accounting because it’s simpler to maintain. You can look at your bank balance to see a transaction or how much cash your business has at any given time.
Accrual accounting records revenues and expenses when they are earned, irrespective of when the money is received or paid out.
For example, if you paid $240 up front for a two-year newspaper subscription, your cash flow statement would show a cash outflow of $240 immediately. On the other hand, your income statement would break down the $240 into each accounting period, usually monthly or quarterly.
Think of it this way: let’s say you started a company. After one year, you ran into cash flow issues, even though your business was profitable. As a small business, you relied on invoices to collect accounts receivable from customers.
As anyone who sends invoices knows, customers don’t always pay on time. Even though your company was profitable, according to your income statement, you were short on cash.
You may have had the best intentions but failed to make payment deadlines because you couldn’t manage your company’s cash outflow and inflow. The relationship between cash flow and profit will vary depending on the type of business. You can be profitable but have times of slow or inconsistent cash flow.