Cash vs. Accrual Basis Accounting: What’s the Difference?
Cash and accrual basis are the two main methods of accounting that businesses will use to record revenue and expenses. Both methods give business owners a view of the company's financial health. The biggest difference? Timing. With cash accounting, revenue and expenses are recorded when the payment is exchanged. With accrual, revenue and expenses are recorded when an invoice is made or a bill is received, regardless of when the payment is processed.
Generally, the use of cash vs accrual accounting is dictated by the IRS and a business's tax filing. Accrual accounting is required for some businesses including:
- C corporations with over $5 million in annual revenue
- Businesses that maintain inventory (unless the inventory is not material for the business)
- Businesses with over $26 million in average annual sales over a 3-year period
- Publicly traded companies (which must follow GAAP)
| How They're Different in: | Cash-Basis | Accrual-Basis |
|---|---|---|
| Income Taxes | Liability incurred when you receive payment | Liability incurred when you record a sale |
| Paying Vendors | Bills are recorded at time of payment | Bills are recorded when they are received |
| Transaction Recording | When money is received or spent | When invoice or bill is made |
Cash Basis Accounting
Similar to how you would manage your personal finances, the cash method of accounting is when you record the flow of cash in and out of your business based on payment dates. Small businesses and sole proprietors without inventory most often use this bookkeeping method.
Examples of Cash Accounting:
A. If you make a sale in November and you receive payment in January, you would record the transaction in your books as revenue in January.
B. If you receive a bill in November and pay in January, you would record the transaction in your books as an expense in January.
Pros
- Easy for small businesses that rely only on cash transactions
- Typically less complex than accrual accounting
- More accurately shows cash flow
- Shows how much money your business currently has in the bank account
Cons
- Timing differences can make it difficult to tell your profitability at a specific period
- Not accepted under GAAP and IFRS
- Not a good indicator of long-term profitability. Can't show profitability if money is tied up in pending orders
- Accounts receivables or payables are not clear from accounting records alone, so they must be tracked using another method
Accrual Basis Accounting
Accrual accounting is when you record invoices and bills at the time of creation, regardless of whether they have been paid.
Examples of Accrual Accounting:
A. If you create an invoice for your services in November, but your customer does not pay until January, you would record the invoice in your books as revenue in November.
B. If you receive a bill in November for payment due in January, you would pay the bill in January and record the bill in your books as an expense in November.
Accrual accounting attempts to better match an expense with the revenue in a time period, thus providing a more accurate picture of profitability.
Pros
- You get a more accurate picture of profitability during a specific time period
- Accepted under GAAP and IFRS
- It's easier for investors to see how the company is performing before any investment is made
Cons
- You could pay income taxes on money you haven't received
- More complicated and challenging to manage than cash basis accounting
Accounting Method Effects On Taxes
The method you choose for recording financial transactions will impact your tax liability. With Cash-basis accounting, taxes are calculated based on the payments made and payments received. With accrual-basis accounting, taxes are based on the creation date of invoices and bills, regardless of when cash is exchanged.
The IRS mandates the type of accounting certain businesses must use to comply with their guidelines. If you employ a CPA, they might recommend one method over the other based on various factors, including your business type and how much income the business is bringing in. The Generally Accepted Accounting Principles (GAAP) requires publicly traded companies to use the accrual method of accounting. As such, it is the most widely used method of business accounting. You must generate financial statements through the accrual method for the IRS to be able to audit them. The accrual method is also mandatory for businesses that manage inventory.
Per the IRS, only businesses with gross receipts under $26 million can use the cash basis method, and they can choose whether to use cash or accrual basis accounting. If you manage inventory, you Since some small business owners and startups have a choice between what method to use, the tax implications of that choice should be very carefully considered because it must be declared to the IRS
FAQ
Q: Can I use a hybrid method of accounting?
A: For financial reporting and tax purposes, you may consider using a combination of cash and accrual accounting. If you prefer to pay taxes only on money already earned, you could run your business operations on accrual accounting but use cash accounting to report to the IRS. This method involves more work, but it may be preferable for certain businesses that want to ensure they do not overpay on their taxes.
Q: How does accounting software help me with these methods?
A: Software like QuickBooks allows you to choose between the two methods for your accounting system and then automates the respective processes. If you are using the accrual method, QuickBooks's double-entry accounting feature will automatically record transactions accurately. Some software will give you views of both cash and accrual accounting.
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