How Do Accrual Accounting and Cash Accounting Differ in Financial Management?

Accrual accounting records transactions when they are earned, while cash accounting records them when money changes hands. Choosing the right method impacts taxes, financial planning, and cash flow management for businesses.

By Brad Nakase, Attorney

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Table of Contents

1. What is the difference between cash basis accounting and accrual accounting in financial management?

2. How Do Most Small Businesses Keep Track of Their Money?

3. Cash-Basis Accounting

4. Accrual Accounting

5. A Mixed Approach to Accounting

6. Advice on Choosing an Appropriate Accounting Approach for Your Company

7. Particular Factors to Think About

8. Comparison between Accrual and Cash Basis Accounting with an Example

9. When Is Cash-Basis Accounting Appropriate?

10. What Situations Call for Accrual Accounting?

11. Other Approaches to Accounting

12. Accounting Software and Its Benefits

13. In Conclusion

What is the difference between cash basis accounting and accrual accounting in financial management?

A system for recording financial transactions, including income and expenditures, is essential for any company. Which accounting technique you choose with can influence your tax situation, your capacity to secure a business loan, and the financial decisions you make for your company’s operations.

How Do Most Small Businesses Keep Track of Their Money?

The two main ways that businesses keep track of their money are cash-basis accounting and accrual-basis accounting.

When money comes in and goes out is when the two approaches diverge. When you use different accounting methods might have an impact on your profit, loss, and income tax. In contrast to the accrual technique, which centers on future revenue and expenditures, the cash method gives immediate acknowledgment of both types of income and expenditures.

Even while the accrual approach is more complicated, it often paints a more true image of a company’s financial health than the cash method. There are benefits and drawbacks to each option. Read on to find out which one may work best for your company.

Being aware of your sources of income and the regular expenses you may anticipate is crucial for every business owner. You might be better equipped to manage accounting and choose the most appropriate accounting approach if you have a firm grasp of how money is coming into your company.

Expenses for small businesses typically come from:

Payroll
Utilities
Office space
Inventory
Equipment & Supplies
Advertising/Marketing
Insurance

Cash-Basis Accounting

For those new to accounting, the cash approach is the way to go. Most individuals and small companies opt to file their taxes on the cash basis because it is easy and straightforward.

The receipt of payment, whether actual or constructive, triggers the recording of revenue under the cash method. To receive money in a constructive manner, it must be credited to your account or otherwise made freely available to you. Imagine, for the sake of argument, that you get payment for your work in December.

You are required to record the income in December as you have control over it then, even though you don’t deposit the check until January. When you get payment in the form of property or services instead of cash, the fair market value of those assets is considered income. This includes payments made through electronic transfers, checks, or credit cards.

When you pay suppliers for items or services, that’s when you record the expenditure under the cash method. Take rent as an example; it’s usually due on the first of every month. You should note the payment if it is made ahead of schedule, for example, on the 28th of the prior month. The cost will be recorded on the day that payment is received, even if it is received beyond the due date (for example, on the 5th of the month for rent).

Accrual Accounting

Instead of documenting income and costs as they happen or as money changes hands, the accrual method of accounting records them when they are completely earned as well as when they are used. To be more precise, you can’t claim revenue until the circumstances that make it possible have materialized. That way, you can do a “economic performance test” and get a very good idea of how much money is coming in.

So, suppose you take an order, process it, and send out the items. All the necessary circumstances have transpired to establish your right to payment, and you can ascertain the appropriate amount of payment, therefore you would record the revenue upon shipment. You proceed immediately upon receipt of payment.

When it comes to spending, the same principles apply. Take rent as an example; it’s usually due on the first of every month. Regardless of whether you pay early or late, this is the date for recording the cost according to the accrual approach.

A Mixed Approach to Accounting

The Internal Revenue Service recognizes two main approaches to bookkeeping, but it also permits a third, hybrid approach in some cases. Because it is less well-defined and more complex to govern, this strategy is usually not employed. Any mix of cash and accrual systems is acceptable to the IRS provided:

You constantly use the strategy.

The hybrid accurately shows your income and expenditures.

This term, as you can see, is very open to several interpretations, which can cause issues during audits. The optimal course of action for the majority of company owners would be to regularly use either the cash or accrual technique.

Advice on Choosing an Appropriate Accounting Approach for Your Company

Since it establishes the timing of revenue recognition and cost deductions, the accounting technique you choose is critical for tax planning. Some companies are required to employ the accrual technique rather than the cash approach due to specific circumstances. But new provisions in the tax code make it easier to employ the cash option if that’s what you choose.

There is no universally optimal approach to accounting; rather, each system has its own set of pros and cons. To make an informed decision as a small business owner, you should weigh the benefits and drawbacks of cash vs. accrual accounting.

It is simpler to understand and implement cash-basis accounting. If you’re using the cash approach, which is straightforward (you record money as it comes in and spending as it goes out), you might not even need an accountant or bookkeeper. Your accounting software makes it easy to record transactions.

A cash-basis approach reveals the flow of cash. You may get a more accurate sense of your company’s liquid assets using the cash approach as it tracks the money coming in and going out of your company. What this means is that your accounting process is similar to keeping tabs on cash flow.

It is possible for accrual accounting to postpone the movement of funds. Due to its practice of recording revenue and costs at the time they are earned or spent rather than when cash actually changes hands, the accrual approach has the potential drawback of providing a delayed representation of cash flow. This might lead to situations where a company seems well on paper but is actually having trouble making ends meet.

An option for managing cash flow is invoice factoring. Companies may want to look into invoice factoring as a solution to their cash flow problems. Businesses can gain access to working capital through this financial technique, which involves selling accounts receivable to a third party at a discount. For companies concerned with keeping track of their money, it’s a sensible option. Even though accrual accounting may take some time, this enables them take care of their urgent financial obligations.

When compared to the accrual system, the cash method of accounting lacks control. Using the accrual approach to organize transactions makes publishing them easier and lessens the likelihood of mistakes.

There are pitfalls to using cash-basis accounting. When it comes to revenue, the cash technique isn’t completely accurate. It doesn’t account for future costs that the company will have to pay, for instance, or it doesn’t represent income that has been invoiced but not yet received.

Not all large companies can use the cash technique. If the average yearly gross receipts of a C corporation or a partnership with a C corporation partner surpass a predetermined monetary amount (in this case, 26 million dollars as of 2020), then the business is unable to use this strategy. We refer to this as the gross receipts test.

Certain accounting standards prohibit larger organizations from using the cash-basis technique. For reasons that will become clear later on, large corporations are required by accounting standards to choose the accrual approach.

Particular Factors to Think About

Most businesses, especially those with stock on public markets, adopt the accrual technique. The accrual method is widely used because it allows for the smoothing out of profits over time. This is because all revenues and costs are recorded as they are generated.

The cash basis approach can show more dynamic perspectives on profitability as it only captures these when money changes hands.

Take the cash basis technique as an example. In Q4, when customers are buying for the holidays, shops would appear to be making a ton of money. Nevertheless, Q1 of the next year would reveal their lack of profitability due to the drop in consumer spending that follows the Christmas season.

There are benefits and drawbacks to both approaches. Each one shows how a company’s finances are doing from a different angle. Before putting their money into the market, investors should weigh the pros and cons of both approaches.

As a general rule, accrual-based accounting is used by most firms that individuals are considering investing in. It is important to be wary of small businesses that use cash-based accounting practices.

Comparison between Accrual and Cash Basis Accounting with an Example

Let’s pretend you run a company that deals in the sale of various pieces of machinery. Under the cash approach, you won’t have to wait for the buyer to physically hand over the cash or a check before you can register the sale of $5,000 worth of equipment.

Regardless matter how long it takes to collect the $5,000—it might be days, weeks, or months—the accrual system records it as income on the day the transaction was made.

When it comes to costs, the same rule holds. The cash method does not record the amount until the corporation pays the power bill, in this case $1,700. In contrast, the day the business gets the invoice triggers the accrual method’s entry of the $1,700 as an expenditure.

When Is Cash-Basis Accounting Appropriate?

Your business is just getting off the ground. Since the cash technique is more intuitive than the accrual method, it could be best to stick to the basics when you’re just starting out.

You would want more precise tax management. You may use this strategy to delay or speed up revenue and/or spending as we approach the conclusion of the year. If you do some work in December but don’t want to pay for it until next year, you can put it off until the next year and avoid paying taxes on it.

What Situations Call for Accrual Accounting?

You have an inventory. Keeping inventory is mandatory if you fail to meet the requirements of the gross receipts test mentioned above. It is routine practice to do so when using the accrual approach.

Payables and receivables are two areas that you should monitor closely. To report results using the cash approach, all you have to do is track when you get money or pay for something. However, the accrual technique provides a better grasp of your accounts receivable (A/R) and accounts payable (A/P) if you wish to monitor what’s due in order to follow up as necessary.

You should look at the financial health of your organization from a long-term perspective. Within a certain time frame, events may be more easily observed, allowing you to respond appropriately to signs of growth or stagnation in the company.

You should follow GAAP. Most companies with revenue above $25 million are required to adopt the accrual method according to the Generally Accepted Accounting Principles (GAAP) standard for accounting regulations. Financial reporting follows these guidelines.

Other Approaches to Accounting

Sometimes, rather than cash or accrual, other kinds of accounting systems are more appropriate. Companies also make use of various accounting techniques, such as:

Installment approach: In addition to the cash and accrual methods, the installment method can be used to declare gain on sales if payment arrives in more than one year. This way, you may divide up the profit and bring your tax records into closer harmony with when you really get the money. In the case of inventory sales, this strategy is not applicable.

Method for determining the completion percentage of long-term contracts: The construction industry often use this technique since developing a structure from the ground up might take a long time. The rule permits the postponement of revenue and expenditures until the conclusion of contracts where such contracts go into the subsequent year (with restrictions). This technique of accounting is not applicable to house building contracts that are being worked on by smaller contractors or larger contractors.

Accounting Software and Its Benefits

When deciding on an accounting system, accounting software may be an important tool. Keeping correct financial records doesn’t require you to have a degree in accounting. You may usually choose between the cash and accrual methods when configuring your accounting software. You may even be able to toggle between various ways to see reports in some programs.

When comparing the methods’ effects on your P&L and tax liabilities, this might be helpful. Be aware that if you are currently using one way of accounting and are interested in switching to another, you will need to submit an IRS form requesting a change in accounting method and pay any applicable fees.

In Conclusion

There are two methods for keeping track of money coming in and going out: accrual accounting and cash basis accounting. Accrual accounting records transactions when funds are earned or expenses are paid, whereas cash basis accounting records transactions when funds are received or expenses are paid. There are few situations when cash basis accounting is acceptable, but generally speaking, accrual accounting is what the law requires.

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