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- Cash Basis vs Accrual Basis: Pros And Cons Of Cash And Accrual
Cash and accrual are the two primary choices for business accounting. When you start a small business, you’ll need to decide which method to use to best track your business finances. The difference between cash and accrual accounting is the timing of when sales and purchases are recorded in your accounts.
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What is cash accounting?
With cash accounting, you report expenses when you pay them and income when someone pays you. This system of accounting recognizes revenue and expenses only when money changes hands.
What is accrual accounting?
Accrual accounting matches revenues to expenses at the time in which the transaction occurs rather than when payment is made or received. This method allows the current cash inflows or outflows to be combined with future expected cash inflows or outflows to give a more accurate picture of a company's current financial position.
What is the difference between cash and accrual?
Investopedia outlines how the accrual and cash method differ:
The main difference between accrual and cash basis accounting lies in the timing of when revenue and expenses are recognized. The cash method is a more immediate recognition of revenue and expenses, while the accrual method focuses on anticipated revenue and expenses.
Pros of the cash method
Pros of the cash method include:
- It’s easy to understand. Cash basis accounting tends to be simpler to understand than other accounting methods. If you choose to implement the cash method for your small business, it may not be necessary to seek the help of a professional accountant.
- Cash flow is shown. The cash method most resembles a cash flow statement. It provides an accurate picture of how much cash your business actually has on-hand.
- It’s a single-entry system. The cash method can be done with a simple single-entry system, so a complex accounting program is not always necessary.
Cons of the cash method
Despite the benefits, there are cons to using cash-basis accounting. Consider the following before committing to one method.
- Doesn’t show the full picture but a limited look at your income and expenses. This could impact decision-making as well as growth.
- Business’s liabilities are not shown. You may think you have more money to spend than you actually have.
- Customer’s liabilities not shown. This could cause you to forget about unpaid customer debts.
- Restricted use. You cannot use cash-basis accounting if you:
- Sell products or services on credit
- Have gross receipts higher than the IRS requirements
- Need inventory to account for income
- If you offer credit to customers, you must use accrual accounting
- C corporations cannot use cash-basis accounting or partnerships with average annual gross receipts for the three preceding tax years exceeding $25 million. According to the IRS, you generally cannot use cash accounting if you produce, purchase, or sell merchandise and rely on inventory. However, there is an exception. If you are a small business taxpayer, you can choose not to keep an inventory if you have average annual gross receipts of $25 million or less for the three preceding tax years.
- Potentially difficult to switch over. As your business grows, you may decide (or be required) to change accounting methods. To change from cash to accrual, you need to make some adjustments.
When transitioning your accounting books from cash to accrual, you must:
- Add accrued and prepaid expenses
- Add accounts receivable
- Subtract cash payments, cash receipts, and customer prepayments
- You must also request a change in your accounting method with the IRS. To do so, file Form 3115, Application for Change in Accounting Method.
Pros of the accrual method
If you’re choosing an accounting method, here are the benefits of using an accrual method:
- Gives an accurate picture of overall cash flow. Many business transactions occur over a period of several months and therefore several accounting periods. Accrual accounting reflects that income and expenses generated in one month can carry over into the next month or even longer.
- Investors prefer accrual accounting. A business that uses accrual accounting is often looked at as more permanent and established than businesses that use cash-basis accounting methods.
- It's the preferred method for GAAP. The Generally Accepted Accounting Principles set forth by the Financial Accounting Standards Board prefers accrual accounting over cash-basis accounting because the financial statements for a business that uses accrual accounting are deemed more accurate since the transactions reflect when they actually took place instead of when money is exchanged. Learn more about GAAP on the accounting.com blog: What is GAAP?
- Planning becomes easier. Accrual accounting allows you to account for all of your revenue and expenses within a specific time period. This makes it easier to budget for expenses and income to assist with staffing, inventory levels, and other operational areas of concern. One of the other benefits of accrual accounting is that it can also help reduce your tax burden by issuing invoices at the beginning of the year and then at the end of the year.
- Helps avoid overspending by incurring the expense and not overdrafting before payment.
Cons of the accrual method
Here are details about the accrual method to consider.
- Small companies might lack the staff needed to manage this method. Larger businesses typically have staff – even an entire team – dedicated to tracking and reporting transactions.
- Accrual basis accounting requires at least monthly reporting. In order to remain accurate, accrual accounting needs frequent reports generated like monthly financial statements. But accounts receivable and accounts payable reports are often generated on a more frequent basis.
- Paying taxes on money not yet received. An advantage to using accrual accounting is that you can report income when the sale is incurred instead of waiting until you have cash on hand, this also means a business pays taxes on money it hasn't received.
How to choose the best accounting system for your business
If your business is a corporation (other than an S corp) that averages more than $25 million in gross receipts each year, the IRS requires you to use the accrual method. If your business doesn’t hit those criteria, the cash method should be used.
However, the cash method usually works better for smaller businesses without inventory. If you’re an inventory-heavy business, your accountant will probably recommend you go with the accrual method.
To change accounting methods, you need to file Form 3115 to get approval from the IRS. File this form to request a change in either an overall method of accounting or the accounting of any item.
DISCLAIMER: The SmartBiz® Small Business Blog and other related communications from SmartBiz Loans® are intended to provide general information on relevant topics for managing small businesses. Be aware that this is not a comprehensive analysis of the subject matter covered and is not intended to provide specific recommendations to you or your business with respect to the matters addressed. Please consult a certified accountant or tax professional for further information.