When it comes to different accounting methods, we know it can be confusing. But what exactly is the Difference Between Cash and Accrual and what is best for your business? Mainly, it lies in the timing of when revenue and expenses are recognized. Specifically:
- The cash method is a more immediate recognition of revenue and expenses exactly when the cash enters or leaves your bank account
- The accrual method focuses on anticipated revenue and expenses when they are earned or incurred.
Each method has advantages and disadvantages. One main item is that the cash method is more straightforward. However, only the accrual basis is accepted by Generally Accepted Accounting Principles (GAAP), which is a set of rules established by the Financial Accounting Standards Board (FASB). Depending on your company’s size and circumstances, it may be a no-brainer which method fits best. We will take a deeper dive below.
Cash Basis Accounting Method
With this method, revenue is reported on the income statement only when cash is actually received. On the other hand, expenses are only recorded when cash is paid out. This is a good method for small business and it’s how most account for their personal finances.
Small businesses find it easier to use this method since they need to keep a tight fist around their cash flow at all times and is easier to track since there is generally less items to record within a small business.
This method also means that your revenue will not be subject to tax until cash is actually in the bank. However, at times, it can distort the true financial state of a business.
For example, you may have a large order that came through that makes you appear you have a large cash balance at any given time. However, you haven’t paid out the bills for that order yet, which means your account payables haven’t been paid yet. This will make your bank statement look exceptionally good. Investors may think that your business is about strong and growing, but perhaps it’s losing money because of the unpaid accounts payable that haven’t been handled yet.
Another example would be if a store used the cash method and sold an extreme amount of items during Q4 over the holiday season, they may look good then, but would look unprofitable in Q1 as customer spending declines after the holiday rush.
By not recognizing accounts receivable or accounts payable, it could be hard to prove what you have when looking for new investors.
Accrual Accounting Method
The accrual accounting method, on the other hand, will only post revenue when it is actually earned. When a product or service is delivered to a customer, income will be recorded with the expectation that money will be paid for that product or service in the future. This also means that expenses of these goods and services are also recorded, despite possibly not yet having the cash for the sale of the item.
This method is used by larger companies like publicly traded companies. It can be more useful for a larger business than the cash method because it smooths out earnings over time since it accounts for all revenues and expenses as they’re generated. It is, however, more complicated and can be more labor-intensive.
That means the accrual method gives a more realistic idea of income and expenses during a time period, which provides a better long-term picture of the business for investors and management. It can also be helpful for companies with large amounts of inventory.
The downside, however, is that you may not have accurate awareness of the cash flow. A business can appear to be very profitable while the bank account is empty. That means it’s imperative to monitor a cash flow statement for the business, as well.
Let’s Take a Look
This is a small example that shows the difference between the Cash and Accrual method of accounting and how they can yield in a different result at the end of the time period.
| Item | Cash | Accrual |
| Received a payment of $3,000 from an invoice sent in the prior month | Records revenue of $3,000 | Does not record (revenue was recorded in the prior month) |
| Sent out an invoice of $1,000 for a project to be completed later this month | Does not record (cash hasn’t been received) | Records revenue of $1,000 |
| Paid $125 for a bill you received in the prior month | Records expense of $125 | Does not record (expense was recorded in the prior month) |
| Received a bill of $200 from a contractor | Does not record (cash hasn’t been paid) | Records expense of $200 |
| Net profit for month | $2,875 | $800 |
As you can see, under the cash basis method, you claim a much higher net profit than you do under the accrual method. It’s easy in this example to see how much difference can be seen in a company’s profit and cash flow just by deciding which accounting system may work best for your business.
Both methods have their advantages and disadvantages, and each only shows different pieces of the financial health of a company. Understanding both the accrual method and a company’s cash flow with the cash method is important when running a business.
As the old adage goes, “timing is everything”.
If you have questions, please reach out to us here or give us a call at 608-225-4350.