How should you record your business transactions—when cash changes hands or when a sale is made?

Choosing the right accounting method is a crucial decision for any business. It affects how you track income, manage cash flow, and pay taxes. 

Cash accounting records transactions when money is received or paid, giving a straightforward view of cash flow. 

Accrual accounting records transactions when they are earned or incurred, offering a fuller picture of financial health. The right choice depends on your business size, transaction type, and tax needs.

In this post, we compare cash and accrual accounting methods, highlight their key differences, and help you choose the one that fits your business best. Whether you're starting out or looking to switch methods, this guide will help you make a clear decision.

Quick overview of cash and accrual-based accounting

Choosing the right accounting method is crucial for accurate financial reporting. Understanding the two main approaches—cash basis and accrual basis accounting—can help you make the best decision for your business.

Each method has its advantages and drawbacks, impacting how transactions and financial events are recorded and reported. Let’s explore these methods to see how they differ and which might be more suitable for your needs.

Cash-basis accounting

In cash-basis accounting, transactions are recorded only when cash is exchanged. This means income is recorded when received, and expenses are recorded when paid. For example, if a company receives payment for a service in December, it records the revenue in December, even if the service was provided earlier. 

This method is simple and provides a clear view of cash flow. However, it does not account for receivables or payables, which can be a limitation in understanding a company's financial position.

Accrual-basis accounting

Accrual basis accounting records transactions when they occur, regardless of when cash changes hands. Revenue is recognized when earned, and expenses are recognized when incurred. 

For instance, if a company provides a service in December but gets paid in January, it records the revenue in December. This method offers a more accurate picture of financial performance and obligations, reflecting all earned income and incurred expenses within the reporting period. However, it is more complex and requires tracking receivables and payables.

What makes them different?

The key difference between cash and accrual accounting lies in the timing of transactions. Cash basis accounting focuses on cash flow, recording transactions only when cash is received or paid. 

In contrast, accrual-based accounting provides a comprehensive view of financial performance by recording transactions when they occur, regardless of cash movement. While a cash basis is simpler, an accrual basis offers a more accurate representation of a company’s financial status and performance.

What is cash accounting?

Cash accounting records transactions when cash changes hands. Revenue is recognized when it is received, and expenses are recorded when they are paid. This method is straightforward and focuses on actual cash flow, providing a clear picture of cash on hand.

Pros

• Simplicity: Cash accounting is easy to understand and implement. It does not require tracking receivables or payables.
• Immediate cash flow tracking: Businesses can see their actual cash position at any given time, which helps in managing day-to-day operations and ensuring there is enough cash to cover expenses.
• Reduced administrative burden: With fewer records to manage, the accounting process is less complex and time-consuming, which can be beneficial for small businesses with limited resources.

Cons

• Limited financial insight: Cash accounting does not account for receivables and payables, which can lead to an incomplete view of the business’s financial health.
• Inaccurate profit reporting: Revenue and expenses may not match up, leading to potentially misleading profitability information, as transactions are only recorded when cash is received or paid.
• Not GAAP compliant: This method is not compliant with Generally Accepted Accounting Principles (GAAP), making it unsuitable for larger companies or those seeking external investment.
• Poor matching of income and expenses: The timing of cash receipts and payments can distort the actual financial performance, as income and expenses are recorded only when cash is involved.

What is accrual accounting?

Accrual accounting records transactions when they occur, regardless of when cash is exchanged. Revenue is recognized when earned, and expenses are recorded in connection with revenue. This method provides a more comprehensive view of a business’s financial position.

Pros

• Accurate financial picture: Accrual accounting provides a clearer view of a company’s financial health by matching revenues with expenses in the same period.
• GAAP compliance: It meets GAAP requirements, making it suitable for larger businesses and those seeking investors or loans.
• Better performance measurement: By recognizing revenues and expenses in tandem, businesses can better assess performance and make more informed decisions.
• Enhanced planning and forecasting: This method allows for more accurate financial forecasting and budgeting, as it accounts for receivables and payables.

Cons

• Complexity: Accrual accounting is more complex and requires more detailed record-keeping, which can be challenging for smaller businesses without dedicated accounting resources.
• Delayed cash flow insight: Since transactions are recorded before cash is received or paid, businesses might face cash flow issues despite showing a profit.
• Higher administrative costs: The need for more detailed tracking of transactions and adjustments can lead to higher administrative costs.

Example showing how cash and accrual accounting work

1. Cash accounting example

A small consulting business provides services worth $5,000 in December 2023, but the client pays in January 2024. The business also paid $2,000 in December 2023 for office supplies.

Cash accounting record

December 2023 Income Statement

• Income: $0
• Expenses: $2,000
• Net Profit: -$2,000

January 2024 Income Statement

• Income: $5,000
• Expenses: $0
• Net Profit: +$5,000

2. Accrual accounting example

The same consulting business provides services worth $5,000 in December 2023 and receives payment in January 2024. The business also paid $2,000 in December 2023 for office supplies.

December 2023 Income Statement

• Income: $5,000
• Expenses: $2,000
• Net Profit: $3,000

January 2024 Income Statement

• Cash flow:
  • Income received: $0
  • Expenses: $0
  • Net cash flow: $0

Key differences between Cash and Accrual

Cash accounting: The income is recorded in January 2024 when the payment is received, while the expense is recorded in December 2023 when the payment is made.

Accrual accounting: Both the income and expense are recorded in December 2023, reflecting the period in which the services were provided and supplies were purchased.

How does each method affect your taxes?

The choice between cash and accrual accounting can significantly impact how and when you report income and expenses for tax purposes. Under cash accounting, income is recorded when it is received, and expenses are recorded when they are paid. 

This means that if you receive payment or make purchases at the end of the year, it will affect the tax year in which those transactions are recorded. 

For instance, receiving a large payment in December can increase your taxable income for that year, while paying for expenses before year-end can reduce your taxable income. This method can provide some flexibility in managing taxable income by timing receipts and payments.

That said, accrual accounting records income and expenses when they are incurred, regardless of when cash changes hands. This method aligns income and expenses with the period they relate to, which can provide a more accurate picture of financial performance but may lead to different tax implications.

For example, if you invoice a client in December but receive payment in January, the income will be recognized in December, potentially increasing your tax liability for that year. 

Similarly, if you incur expenses in December but pay them in January, those expenses are recorded in December, reducing taxable income for that year. 

Accrual accounting can result in tax liabilities being recognized before actual cash flow occurs, which might impact cash management strategies.

Cash or accrual: Find the best fit for your financial strategy

Choosing between cash and accrual accounting is a fundamental decision that affects how you manage your business finances.

Using a tool like DayZero can significantly streamline the accounting process, making it easier to manage and report financial data regardless of the method you choose. 

DayZero automates key tasks, reduces the risk of errors, and provides templates tailored to your specific business requirements. By integrating such tools, you ensure that your financial records are accurate and up-to-date, allowing you to focus more on strategic decisions and less on administrative tasks.

Frequently Asked Questions (FAQs)

Take a look at few of the questions we receive constantly from DayZero customers.

1. Who can use the cash accounting method?

The cash accounting method is typically used by small businesses and sole proprietors. It is suitable for businesses that do not carry large amounts of inventory or have complex transactions. This method records revenues and expenses only when cash changes hands, making it simpler and more straightforward. Businesses with annual revenue under $26 million (as per IRS guidelines) can choose cash accounting, provided they do not maintain inventory.

2.Who must use accrual accounting?

Businesses that exceed $26 million in annual revenue or those that maintain significant inventory must use accrual accounting. This method is required for larger companies and publicly traded businesses. Accrual accounting records revenues and expenses when they are incurred, regardless of when cash is received or paid. This provides a more accurate picture of financial performance and is necessary for businesses that need to follow Generally Accepted Accounting Principles.

3.What is a prepaid expense and how is it recorded in the ledger as a transaction?

A prepaid expense is an advance payment for goods or services that will be received in the future. For example, paying for insurance coverage before it begins is a prepaid expense. In the ledger, it is recorded as an asset initially. As the benefits of the prepaid expense are realized over time, the amount is gradually moved from the asset account to an expense account. For instance, if you pay $1,200 for a one-year insurance policy, you record $1,200 as a prepaid expense. Each month, $100 is then transferred from the prepaid expense account to the insurance expense account.

4. What is the journal entry for accrual?

An accrual journal entry is made to recognize revenue or expenses before cash transactions occur. For example, if a company earns $500 in services but has not yet received payment, the journal entry would debit Accounts Receivable for $500 and credit Service Revenue for $500.