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.
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:
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:
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.
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 |
Business Size | Under $26 million revenue, you can choose method | $26 million revenue or more, you must use accrual method |
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
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.
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.
Need accounting software? Automate your cash or accrual accounting with software. Get free recommendations.