Cash vs. Accrual Accounting: What’s Best for Your Small Business?

As a small business owner, it’s important to understand the difference between the two main methods of accounting, cash and accrual. Even if you don’t handle your own financial reporting, it’s vital to know how each one works so you can choose the best bookkeeping practices for your business.

Let’s take a look at the differences and respective implications of each accounting method.

What Is the Cash Method?

With the cash basis of accounting, you record income as it’s received and expenses as they’re paid. This does not take into account any accounts receivable or payable, as it only applies to payments from clients when the cash is in hand, and expenses when the transaction clears your bank account.

For example, if you invoice a client for $1,000 on March 1 and receive payment on April 15, you would record the income in April’s bookkeeping. This is when the money was received and in hand.

Many small business owners choose the cash method of accounting because it’s a simplified bookkeeping process. It’s easy to track money as it moves in and out of your bank account because there’s no need to record receivables or payables.

Additionally, your small business doesn’t have to pay income tax on any revenue until the moment it’s deposited into your bank account.

One downside to using the cash basis of accounting is that it can produce an inaccurate overall picture of your finances. Since it doesn’t account for all incoming revenue or outgoing expenses, it can lead you to believe you’re having a very high cash-flow month, when in actuality this is a result of last month’s work.

It’s important to note that this method does not take into account any accounts receivable or accounts payable. This is because it only applies to payments from clients, in the form of cash, cheques, credit card receipts, or gross receipts, when payment is received.

Who uses cash basis accounting? 

Because of its simplicity, many small businesses and sole proprietors use the cash basis method as their primary method of accounting. If your business makes less than $25 million in annual sales and does not sell merchandise directly to consumers, the cash basis method might be the best choice for you. 

Some of the benefits include:

• Shorter learning curve
• Fewer items to record
• Easier tracking of expenses and revenue

Example of cash basis accounting 

Using the earlier example where you invoice a client for $1,000 on March 1 and receive payment on April 15, you would record the income as received for the month of April, since that’s when you actually had the money in hand.

So the breakdown looks like this:

1. The invoice is sent for $1,000 in March
2. You do nothing in March 
3. You receive payment in April
4. You record the income in April

What Is Accrual Accounting?

The accrual basis of accounting is basically the complete opposite of the cash method. Income and expenses are recorded when they’re billed and earned, regardless of when the money is actually received. It is worth noting that accounting standards outlined by the international financial reporting standards (IFRS) stipulate the use of accrual accounting for financial reporting, as it provides a clearer picture of a company’s overall finances.

Using the example from above, and applying the accrual basis of accounting, you would record the $1,000 as income in March’s bookkeeping versus in April when you actually received the funds.

The upside to using the accrual method is it gives small business owners a more realistic idea of income and expenses during a certain period of time. This can provide you (and your accountant) with a better overall picture of how your business is doing and where it’s headed in the future.

One drawback to the accrual method is that it doesn’t account for cash flow or funds that are available in your bank account. If you don’t have careful bookkeeping practices, the accrual-based accounting method could be financially devastating for a small business owner, as your books could represent a large amount of revenue while your bank account is completely empty.

Who uses accrual accounting? 

Under IFRS it is expected that businesses use the accrual method of accounting. However, in the US which primarily uses GAAP regulations, only businesses that are either publicly traded or produce over $25 million in sales revenue over a three-year period are required to use the accrual method. 

Example of accrual accounting 

Using the example from above, if a small business bills a client $1,000 on March 1, you would record that $1,000 as income in March’s bookkeeping, even if the funds didn’t clear your account until April 15.

• The invoice is sent for $1,000 in March
• You record revenue in March

The same holds true for accrued expenses. In this case, if your small stationery business buys paper supplies on a credit card in June, but doesn’t actually pay that bill until July, you would still record that as a June expense.

Let’s break this down:

• You bought paper supplies in June
• You record the expense in June

What is the difference between cash and accrual accounting?

Cash accounting records income and expenses as they are billed and paid. With accrual accounting, you record income and expenses as they are billed and earned. 

Why should you choose one over the other? We’ll explain the basics of cash accounting and accrual accounting methods, as well as the pros and cons of each so that you can make an informed decision.

Accrual vs. cash basis: Which is better?

Accrual accounting is the winner if you’re looking solely at popularity, as it’s the most widely used as well as the most accurate when it comes to portraying a holistic view of a company's financial health. It is also a requirement for complying with IFRS. Cash basis accounting is still a popular option, however, due to the simplicity of the overall process. 

Advantages and disadvantages of accrual accounting

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.

This is because accrual accounting gives an accurate picture of how much money you earned and spent within a specified time period, providing a clearer gauge of when a business speeds up or slows down over the course of a business quarter or a full year. Additionally, it conforms to nationally accepted accounting standards. This means that if your business were to grow, your method of accounting would not need to change.

Advantages of accrual accounting:

• Creates a more accurate financial picture: It can give small business owners a more realistic idea of income and accrued expenses during a certain period of time. This can provide you (and your accountant) with a better overall understanding of consumer spending habits and allow you to plan better for peak months of operation.
• Conforms to IFRS principles: Because the accrual method conforms to IFRS, businesses are generally expected to use the accrual method when preparing general purpose financial statements
• Scales with your business: You may not be there now, but in a few short years you could double or triple your revenue. If you already use the accrual accounting method, there’s no need to change, it simply grows with you. 

Disadvantages of accrual accounting:

• More resource-intensive: Many small business owners view it as more complicated and expensive to implement due to complexity and extra paperwork. Since a company records revenues before they actually receive cash, the cash flow has to be tracked separately to ensure you can cover bills from month to month.
• Inaccurate short-term view: The cash method gives you a better picture of the funds in your bank account. If you don’t have careful bookkeeping practices, the accrual accounting method can lead business owners to assume they have more money in their bank accounts than they actually do.

Advantages and disadvantages of cash basis accounting

The cash method of accounting certainly has its benefits, including ease of use and improved cash flow. While the cash basis method of accounting is definitely the simpler option of the two most common accounting methods, it has its drawbacks as well.

Advantages of cash basis accounting:

• Simplified, familiar process: Cash basis accounting is a simplified bookkeeping process that is similar to how you might track your personal finances. It’s easy to track money as it moves in and out of your bank accounts because there’s no need to record receivables or payables. 
• Income taxes: For tax purposes, you don’t have to pay taxes on any money that has not yet been received. For instance, if you invoice a client or customer for $1,000 in October and don’t get paid until January, you won’t have to pay taxes on the income until January the following tax year. For individuals and extremely small businesses, this can be crucial to keeping your business afloat when cash flow is restricted.

Disadvantages of cash basis accounting:

• Inaccurate financial picture: Since it doesn’t account for all incoming revenue or outgoing expenses, the cash accounting method can lead you to believe you’re having a very high cash flow month when in actuality, it’s a result of a previous month’s work.
• No accounts receivable or accounts payable records: Because the method is so simple, it does not require your CPA or bookkeeper to keep track of the actual dates corresponding to specific sales or purchases. In other words, there are no records of accounts receivable or accounts payable, which can create difficulties when your company does not receive immediate payment or has outstanding bills.
• Doesn’t conform to IFRS: If your business were required to prepare general purpose financial statements it would be expected for those to be IFRS compliant or local GAAP compliant, which would require a change in accounting method.

What’s Best for Your Small Business?

The cash method of accounting is the easier of the two to use and maintain since it’s relatively straightforward. The accrual method, on the other hand, requires more bookkeeping because you’re forced to do more recording and tracking.

The cash method gives you a better picture of the funds in your bank account, while the accrual method accounts for money that’s yet to come in. The cash basis gives you an immediate look at your financial picture, while the accrual basis is more of a long-term view.

Some small businesses can choose the hybrid method of accounting, wherein they use accrual accounting for inventory and the cash method for their income and expenses. Accounting software and tools like QuickBooks can help with either method.