Cash vs. Accrual Accounting

Cash versus accrual accounting can be a confusing subject.  Business owners who have never had to deal with the financial side of a business have a lot of questions about it.  The idea that accounts are cash based or accrual based seems to be an obstacle for many business owners and so to help them we have created this blog.  It explains the difference between cash based and accrual based accounting.

Cash accounting versus accrual accounting

Timing differentiates cash basis accounting from accrual basis accounting. When do you report revenue or expenses? It is cash basis accounting if you do it when you pay or receive cash. If you do it when you receive a bill or create an invoice, you are using accrual accounting.

Cash accounting has its benefits, but accrual accounting is a considerably more effective instrument for business management.

Cash accounting system

The cash basis of accounting records revenues and expenses when cash is received and disbursed, respectively. This strategy disregards accounts payable and accounts receivable.

Many small firms choose the cash method of accounting because it is easy to manage. There is no need to track receivables or payables since it is simple to tell when a transaction has occurred (the money is in or out of the bank) and there is no need to track receivables or payables.

The cash technique is also advantageous in terms of keeping track of how much cash the business truly has at any given time; you may view your bank balance to determine the precise amount of resources available.

In addition, because transactions are not recorded until cash is received or paid, the business’s income is not taxed until the cash is in the bank.

Disadvantage of cash accounting

– It may indicate that you are lucrative even though you haven’t paid your expenses.

– It is not helpful when making management decisions because you simply have a day-to-day financial perspective.

Accrual accounting system

Accrual accounting is a system of accounting in which revenues and costs are recorded regardless of when the money is received or paid. For instance, you would record income when a project is completed, not when you receive payment. This method is utilized more frequently than the monetary method.

The accrual basis provides a more accurate picture of income and expenses over a period of time, presenting a long-term view of the business that cash accounting cannot.

Disadvantages of accrual system

– You need to monitor invoices in addition to the bank account.

– You may be required to pay income tax before the consumer has paid you. If the client fails to pay, you can claim the tax back on your next return. 

Note that many businesses maintain their books on a cash basis yet submit their taxes using the accrual method. When it is time to prepare taxes, they move from cash basis accounting to accrual basis.

Hybrid approaches to accounting

Some business types employ a hybrid accounting system. They may utilize accrual accounting for major financial decisions and items like loan applications, but cash-basis accounting to simplify certain tax issues. There are numerous restrictions on who can and cannot do this. Consult with an accountant or tax expert to determine what applies to you.

Should a small company use cash accounting or accrual accounting?

The IRS mandates you to adopt the accrual method if your corporation (other than a S corporation) has averaged more than $25 million in gross receipts over the past three years.

If your business does not meet these requirements, you may adopt the cash method.

However, the cash technique is typically more effective for smaller enterprises that do not carry inventory. Your accountant will likely advise you to use the accrual technique if you’re an inventory-intensive business.

To change accounting techniques, you must submit Form 3115 to the IRS for approval.

Key takeaway

Cash vs. accrual is a fundamental accounting concept that can be confusing to many business owners. The cash method treats income and expenses when cash is received or paid out, while the accrual method records income and expenses when they are earned or incurred. 

By understanding these two accounting concepts, business owners can make better decisions about their accounts, find ways to save money, and more easily complete tax returns.