Accrual vs Cash Accounting

Cash and accrual accounting are the two primary methods of keeping business books. Whether you’re hiring a staff accountant or having a consultant do your books, you still need to understand which method you use and how it works overall.

 

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What is accrual accounting?

Accrual accounting uses an accrual method to record payments—both incoming and outgoing. This simply means the payment is recorded at the time the related transaction is made and not when the money is actually received (or debited).

 

Here are some examples of accrual accounting:

  • You sign a contract with a client to provide 100 cupcakes for $5 each. You provide the cupcakes on December 12 with 10-day net terms. You record the income of $500 on December 12, even though the client might not pay until December 22.
  • You agree to buy equipment for your business totaling $15,000. You purchase the items on September 1 with 30-day net terms. You record the expense of $15,000 on September 1 even though you don’t have to—and may not—pay the invoice until September 30.

Pros and cons of accrual accounting

Accrual accounting provides a clearer overall picture of the business’s financial situation than cash accounting might.

 

For example, in the situation where a business purchased $15,000 in equipment on net-30 terms, the fact that the $15,000 hasn’t left the account yet doesn’t change the financial picture. The business owes that debt; counting the $15,000 cash as an asset on top of counting the $15,000 value of the equipment as an asset gives a false sense of the overall financial situation.

 

Accrual accounting also matches income and expenses, ensuring they’re recognized on the books in the same period. This can help keep financials aligned for tax and reporting purposes.

 

A downside of accrual accounting is that you may count income that never comes. If you provide $10,000 in services with 30-day net terms, accrual accounting has you recording the income when you provide the service. If the client never pays, you now have a new liability against assets you already recorded. You have to take that liability into account in a separate accounting process.

 

What are accrued expenses?

Accrued expenses simply refer to debits on the books that haven’t actually been paid. The example used above, of equipment purchased but not yet paid for, is an example of an accrued expense.

 

Why is accrual accounting important?

Accrual accounting is important mostly because it provides such a real-time, accurate picture of a business’s financials. This makes it a preferred method of accounting for many organizations, and in some cases, companies must use this method and not cash accounting.

 

Who must use accrual accounting?

According to the IRS, corporations, partnerships and tax shelters that report an average of $25 million in annual gross receipts for three years running must use the accrual method. This is also required under generally accepted accounting principles (GAAP). There is an exception for S corporations.

 

Under these rules, most small business owners can decide between the accrual and cash accounting methods.

 

What is cash accounting?

Many small businesses opt for cash accounting because it’s simpler overall. Income and expenses are only recorded when money enters or leaves the account. So, if you do contract work on spec, you don’t record the income until you receive the payment.

 

Here are some examples of cash accounting:

  • You complete a kitchen cabinet build and charge the client $10,000. The client pays half up front and then makes two payments of $2,500 each over the two months following the build. You record the income as $5,000, $2,500 and $2,500 on the dates you receive the payments.
  • You purchase equipment worth $2,000 on 45-day net terms. You don’t deduct the expense until you actually make the payment.

Pros and cons of cash accounting

The big draw for cash accounting is that it’s typically easier to keep track of. You simply credit and debit accounts as the money flows in and out, and you don’t have to worry about matching revenue and expenses.

 

The biggest disadvantage of cash accounting is that it can create a false financial picture, so you have to be careful not to rely solely on the state of your accounts when making business decisions. For example, if you do purchase equipment on credit, you can’t make business decisions based on the total cash you have on hand without remembering that you are taking out that payment soon.

 

Accrual vs. cash accounting example

So, how do cash accounting and accrual accounting stack up against each other in a specific scenario? Imagine that a business that offers online marketing services does work worth $10,000 for a client in December. Here’s a quick look at how each of the accounting methods might make a difference.

  • Accrual method. The work is completed and invoiced on December 15. The client has 30 days to pay. The “income” is recorded on December 15—so it shows up on that year’s revenue reports and tax returns. The cash itself might not arrive in the account until January.
  • Cash method. The work is completed and invoiced on December 15, but the income doesn’t hit the books. The cash arrives and is recorded in January, making it part of the income for the next tax and reporting year.

While the differences between cash and accrual accounting are fairly simply on the surface, accounting overall is complex. SMBs may want to work with or hire an accountant to ensure they’re handling the books accurately.

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