Cash vs Accrual Accounting: Which Method is the Best for My Business?

K9 Bookkeeping is determined to make accounting and bookkeeping easy and accessible for business owners of every type.

This article is from our “Bookkeeping for Dummies” series, a part of that broader mission.

New business owners have to do a lot of planning when starting their businesses. Choosing the proper accounting methodology for their business is an essential and often overlooked step.

Working with a trusted accounting firm that is an expert in setting your business up correctly with the proper methodology can save your company a lot of time and money.

In this article, we will look at what accrual and cash basis accounting are, the pros and cons, and regulations that may require a company to use the accrual accounting method.

What is Accrual Accounting?

The Corporate Finance Institute (CFI) defines accrual accounting as “the recording of revenues that a company has earned but has yet to receive payment for, and the expenses that have been incurred but that the company has yet to pay.”

In other words, accrual accounting records expenses and revenues when they happen versus when payment is completed.

The accrual accounting method uses the matching principle. The matching principle says that expenses and revenues should be recorded at the same time which they were incurred.

Pros and Cons of Accrual Accounting

Regulatory compliance means accrual accounting is mandatory for many companies. However, there are still pros and cons with accrual accounting that need to be considered.

Pros of Accrual Accounting

The accrual accounting method is compliant with Generally Accepted Principles and Practices (GAAP). GAAP was established to bring transparency, the standardizations of methods, assumptions, definitions, and terminology to financial reporting.
The accrual accounting method is more transparent than the cash accounting method. It shows all the revenue coming in and the expenses going out for the same period.
Accrual accounting makes planning easier. It’s easier for businesses to forecast using the accrual method since they can predict recurring revenue and spread expenses over set periods.

Accrual accounting makes finances easier to track over time as revenue and expenses are matched for that specific period. In contrast, cash basis revenue may not be recognized until one period has ended and a new one has begun.

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Cons of Accrual Accounting

Accrual accounting is not as straightforward as cash basis accounting. GAAP lays out the required procedures and rules, but implementing the processes can be complicated.
Companies with cash flow problems can see them worsen in the short term as they switch to accrual accounting. Cash flow problems are one reason many start-ups begin with the cash basis method.
Because accrual accounting can be complicated for business owners to understand, it opens up the possibility of fraud. Business owners must ensure they have the proper control systems and processes to verify their financial statements are accurate.

Companies Required to Use Accrual Accounting and Exceptions

IRS regulations state, “If an inventory is necessary to account for your income, you must use an accrual method for purchases and sales.”

The IRS does have exemptions for Small Business Taxpayers. To qualify as a small business taxpayer, you must have “average annual gross receipts of $26 million or less (indexed for inflation) for the 3 prior tax years, and are not a tax shelter.”

C Corporations in the trade or business of farming, a qualified personal service, or whose annual gross receipts are less than $ 5 million are also exempt from converting from cash basis accounting to the accrual accounting method.

What is Cash Basis Accounting?

Investopedia defines cash basis as “a major accounting method that recognizes revenues and expenses at the time cash is received or paid out.”

Because cash basis accounting recognizes revenue when cash is received and expenses when the bill is paid, it does not use accounts receivable or accounts payable.

Also, with cash basis accounting, income isn’t taxed until the revenue is received.

Pros and Cons of Cash Basis Accounting

If the IRS or GAPP does not mandate your company to use accrual accounting, the cash basis method could be a good fit. However, there are pros and cons to cash basis accounting.

Pros of Cash Basis Accounting

It’s simple to understand and implement. Revenue is recorded when it is received, and expenses are recorded when they are paid. Its simplicity means that a small business owner might not need an accountant or specialized accounting software.
Because cash basis accounting focuses on cash flow, it can provide an accurate picture of the company’s cash on hand. This information is critical as, according to a survey by Business Insider, “82% of businesses that fail, fail because of cash flow problems.”

Cons of Cash Basis Accounting

Cash basis accounting only looks at a company’s income and expenses. This snapshot can be misleading as it does not consider future expenses and long-term profitability.
Business owners can manipulate their numbers to skew how profitable the company is. Sales can be closed and recorded in one period, but expenses might be recorded in the next period.

Businesses are Good Fits for Cash Basis Accounting

As a rule, smaller and newer businesses are best suited for cash basis accounting. Sole proprietorships and companies that provide services and don’t carry any inventory.

It’s important to remember that IRS regulations and requirements for companies to be GAAP compliant may require a business to use the accrual accounting method.

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Conclusion

If you are a sole proprietor or your business does not require inventory, then the cash basis accounting methodology might be a good fit for your business.

However, the cash basis method can’t provide a truly accurate overview of the health of your company’s finances due to its limited reporting. Furthermore, as your business grows, it can be challenging to move from reporting on a cash basis and moving to the accrual accounting method.

Accrual accounting is more transparent and provides a more accurate overview of a company’s financial health. A Congressional Research Service report states, “The accrual basis of accounting is in accordance with GAAP. U.S.-based publicly traded companies are required to file financial reports with the Securities and Exchange Commission (SEC) under GAAP accounting.”

Having a professional accounting service help set your business up with the accrual accounting method in the beginning and can help provide your company with accurate financial practices to help your business grow. In addition, small businesses that outsource their accounting can focus on their business, not the intricacies needed to track financials.

We’re happy you found this article informative! Go back to our blog page to find more tips, tricks and guidance on bookkeeping, to ensure your business is financially sound and ready to grow to the next level.

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