Cash vs. Accrual Basis Accounting: What’s the Difference?

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.

Read on to discover the pros, cons, and examples of each.

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. Small businesses and sole proprietors without inventory most often use this bookkeeping method.

Examples of Cash Accounting:

• A. If you make a sale in June and you receive payment in August, you would record the transaction in your books as revenue in August.
• B. If you receive a bill in June and pay in August, you would record the transaction in your books as an expense in August.

Pros

• Easy for small businesses that rely only on cash transactions.
• More accurately shows cash flow.
• Shows how much money your business currently has in the bank account.
• Recording transactions are more straightforward, so complex accounting systems aren’t usually needed.
• You only pay taxes on the money in your account.

Cons

• Timing differences between when you recognize revenue and expenses can make it difficult to tell your profitability at a specific period.
• Not accepted under GAAP and IFRS.
• Can’t be used for tax purposes if your gross receipts exceed $26M or if you keep an inventory of merchandise.
• Doesn’t give a good indicator of long-term profitability. Can’t show profitability if money is tied up in orders.
• Your accounts receivables or payables are not clear from accounting records alone.

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 June, but your customer does not pay until August, you would record the invoice in your books as revenue in June.
• B. If you receive a bill in June for payment due in August, you would pay the bill in August and record the bill in your books as an expense in June.

In both of these examples, your balance sheet would show the money from those unpaid bills and invoices, and you would be paying taxes on the invoices and accrued expenses whether or not you pay the invoices during that tax period. Additionally, your income statement will show an incomplete view of your company’s financial situation. Therefore, you will want to generate regular cash flow statements to know how much money your business has on hand before making major financial decisions.

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 money is actually taken in.

Cons

• Cash flow statements need to be calculated separately.
• 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 and transactions you have already made. With accrual-basis accounting, taxes are based on invoices and bills you may or may not have paid.

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, 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’s

Can I use a hybrid method of accounting?

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.

How does accounting software help me with these methods?

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.