- Cash basis is much simpler and more straightforward than accrual accounting.
- Businesses incur revenue and expenses at different times based on which type they use.
- Accrual accounting is required for many businesses.
- This article is for entrepreneurs and professionals interested in accounting software and practices.
Cash basis lets businesses record income and expenses only when cash is actually received or paid. Accrual accounting involves tracking income and expenses as they are incurred (when an invoice is sent or a bill received) instead of when money actually changes hands. Cash accounting is much simpler, but accrual is required for certain businesses and preferable for others to leverage certain tax strategies.
Because of the differences between cash and accrual accounting, one method may be more appropriate for your business than the other. Luckily, most accounting software makes it easy to track your business’s finances with both cash basis and accrual methods. Keep in mind, however, that you must decide which method you want to use and then be consistent when tracking your income and expenses.
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Key takeaway: Businesses that start off using one accounting method and decide to change later can do so by filing IRS Form 3115 and getting approval from the IRS to change their accounting method (if they qualify).
Cash vs. accrual accounting
Cash and accrual accounting differ in a number of ways, but the main difference is when income and expenses are actually reflected in a business’s books. Businesses that are eligible to use cash accounting almost always prefer to use that method because it’s simpler and more straightforward.
Because income and expenses are recorded at different times if a business is using cash or accrual accounting, this also impacts when businesses incur tax liability (or benefit) as a result of these transactions.
For example, while businesses using cash accounting incur tax liability when funds from a sale hit their account, businesses using accrual accounting are taxed on sales made in a given year, whether or not those sales have been paid for.
Cash vs. accrual at a glance
|Category||Cash basis||Accrual basis|
|When transactions are recorded||When cash is received or money is spent||When a sale occurs or an expense is incurred|
|Tax liability incurred||When the income is received||When the income is recorded|
|Ease of use||Very simple and straightforward||More complex and time-consuming|
|Required for businesses of a certain size||No||Yes|
Pros and cons of cash basis accounting
Cash basis accounting is a method where revenue is recorded when the cash is actually received; likewise, expenses are recorded when they are paid. Cash accounting does not acknowledge or track accounts receivable or accounts payable. For that reason, the method is best for small businesses that do not stock inventory.
- It lets you see cash on hand. Cash accounting makes it easy to see how much money your business actually has at any given time and provides a snapshot of actual account balances.
- It offers more control over transactions. This can result in more reliable cash management and tax advantages.
- It’s easier to track income and expenses. Just track when you get money or when it leaves your account. You don’t have to track receivables or payables (though you still should).
- There’s less risk of not affording tax payments. Income isn’t taxed until it’s actually in your account.
- It doesn’t show a business’s liabilities. Cash basis accounting makes it difficult to see your business’s liabilities because it doesn’t reflect future payables.
- It’s not appropriate for all businesses. The IRS does not allow companies that make sales on credit or have collected $26 million in gross sales in any one of the past three years to use cash accounting.
- It’s difficult to transition to accrual accounting. If you start out using cash accounting, it can be difficult to transition to accrual accounting later, which can lead to mismanagement of company finances.
Pros and cons of accrual basis accounting
Under the accrual basis accounting method, income and expenses are recorded when they are accrued, not when the money actually comes in or goes out. Accrual basis is the more common method of accounting, and it’s mandatory for corporations that have gross receipts of $26 million or more in any of the past three years. Accrual accounting is also required for businesses that average more than $25 million in gross receipts over the last three years. [Read related article: How to Prepare an Income Statement]
Key takeaway: Accrual accounting is ideal for larger businesses and inventory-based businesses that benefit from depreciation and credit sales.
- It makes it easy to see future revenue and expenses. Unlike cash accounting, accrual basis accounting lets you see a full picture of your business’s finances. This is because you track receivables and payables rather than just money that has been deposited in or deducted from your accounts.
- It provides a more accurate picture than cash basis accounting. Accrual accounting includes receivables and payables, which provide a more comprehensive view of a business’s finances.
- It allows tax savings for depreciation. While businesses that use accrual accounting incur tax liability for sales earlier, they may also be able to take advantage of depreciation (of certain assets) to save money on taxes over the long term.
- It has extensive rules and regulations. Accrual accounting is more involved than cash accounting, and there are rules around specific types of transactions. There are even rules on what types of businesses must use accrual accounting.
- It requires more work than cash accounting. If your company will benefit from accrual accounting (or you’re required to use it), but you don’t have the time to keep the books yourself, you’ll likely have to hire a dedicated accountant.
- It doesn’t reflect money that’s actually available. Accrual accounting shows account balances based on transactions that may not have settled yet, so you may not have as much cash as your records show you having.
- It may require you to pay taxes on income you haven’t yet received. Sales you make at the end of the year will be taxed in the year the sale was made, even if the cash for the sale isn’t received for weeks or months.
Example of how cash and accrual affect the bottom line
Take, for example, a small retail business that completes the following transactions in one month:
- Purchases inventory for $5,000
- Pays $300 in utilities
- Receives a $500 bill for building maintenance
- Makes $8,000 in sales
- Sends a $2,000 invoice for a custom order it fulfilled
Under the cash basis method of accounting, the business has $2,700 in profit for the month. This is because the $500 maintenance expense and $2,000 invoice are not included in the month’s accounting because the funds have not been spent or received. On the other hand, if the business uses accrual accounting, its books will reflect a profit of $4,200 for the month by including all of the income and expenses recorded during that time. [Read related article: How to Calculate Profit Margins]
How to choose the right method for your business
The best accounting method for your business depends on several factors. In general, cash accounting is best for small businesses and businesses that do not carry inventory as part of their operations. Alternatively, large businesses and inventory-based businesses should opt for accrual basis accounting. Small businesses that are expected to grow may also want to start with accrual basis accounting so they’re prepared for future accounting needs.
Depending on what type of business you are, how much money you make, and the types of sales you make, you may not have a choice. The IRS requires certain businesses to use accrual basis accounting.
For example, corporations other than S-corps must use accrual basis accounting if they averaged over $25 million in gross receipts over the past three years. Certain corporations and tax shelters – including those that make sales on credit – are also prohibited from using cash accounting.
If you have the option of cash or accrual accounting, most top accounting software programs make it easy to choose the one you want to use for your business; some even provide guidance to determine which one will benefit you more.
Top business accounting software
All of these options make it easy to choose between cash and accrual accounting, even based on individual accounting reports you’re running (so you can review cash receipts internally and provide your accountant with accrual-based records for tax purposes). [Read related article: Which Version of QuickBooks Is Right for You?]