money and a clock

Cash Basis Accounting vs. Accrual Accounting

By Cameron McCool on October 2, 2019

Contents

The difference between cash and accrual

Cash basis accounting

Accrual basis accounting

What it means to "record transactions"

Diagram comparing accrual and cash accounting

The effects of cash and accrual accounting

The effect on cash flow

The effect on taxes

Should a small business use cash or accrual accounting?

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The difference between cash and accrual

The difference between cash and accrual accounting lies in the timing of when sales and purchases are
recorded in your accounts. Cash accounting recognizes revenue and expenses only when money
changes hands, but accrual accounting recognizes revenue when it’s earned, and expenses when they’re
billed (but not paid).

We’ll look at both methods in detail, and how each one would affect your business.
Cash basis accounting

The cash basis of accounting recognizes revenues when cash is received, and expenses when they are
paid. This method does not recognize accounts receivable or accounts payable.

Many small businesses opt to use the cash basis of accounting because it is simple to maintain. It’s easy
to determine when a transaction has occurred (the money is in the bank or out of the bank) and there is
no need to track receivables or payables.

The cash method is also beneficial in terms of tracking how much cash the business actually has at any
given time; you can look at your bank balance and understand the exact resources at your disposal.

Also, since transactions aren’t recorded until the cash is received or paid, the business’s income isn’t
taxed until it’s in the bank.

Accrual basis accounting

Accrual accounting is a method of accounting where revenues and expenses are recorded when they are
earned, regardless of when the money is actually received or paid. For example, you would record
revenue when a project is complete, rather than when you get paid. This method is more commonly
used than the cash method.

The upside is that the accrual basis gives a more realistic idea of income and expenses during a period of
time, therefore providing a long-term picture of the business that cash accounting can’t provide.

The downside is that accrual accounting doesn’t provide any awareness of cash flow; a business can
appear to be very profitable while in reality it has empty bank accounts. Accrual basis accounting
without careful monitoring of cash flow can have potentially devastating consequences.

What it means to “record transactions”

We’ve talked a lot so far about recording transactions in your books, and how cash and accrual dictates
“when” you do that.
But what does it mean to record a transaction?

Every business has to record all its financial transactions in a ledger—otherwise known as bookkeeping.
You’ll need to do this if you want to claim tax deductions at the end of the year. And you’ll need one
central place to add up all your income and expenses (you’ll need this info to file your taxes).

There are some good DIY bookkeeping options out there. Or if you’d rather have someone else do your
bookkeeping for you, check out Bench.

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Diagram comparing accrual and cash accounting

Cash accounting Accrual accounting

Recognizes revenue when cash has been received Recognizes revenue when it’s earned (eg. when
the project is complete)

Recognizes expenses when cash has been spent Recognizes expenses when they’re billed (eg. when
you’ve received an invoice)

Taxes are not paid on money that hasn’t been received yet Taxes paid on money that you’re still
owed

Mostly used by small businesses and sole proprietors with no inventory Required for businesses with
revenue over $5 million

The effects of cash and accrual accounting

Understanding the difference between cash and accrual accounting is important, but it’s also necessary
to put this into context by looking at the direct effects of each method.
Let’s look at an example of how cash and accrual accounting affect the bottom line differently.

Imagine you perform the following transactions in a month of business:

Sent out an invoice for $5,000 for a web design project completed this month

Received a bill for $1,000 in developer fees for work done this month

Paid $75 in fees for a bill you received last month

Received $1,000 from a client for a project that was invoiced last month

The effect on cash flow

Using the cash basis method, the profit for this month would be $925 ($1,000 in income minus $75 in
fees).

Using the accrual method, the profit for this month would be $4,000 ($5,000 in income minus $1,000 in
developer fees).

This example displays how the appearance of income stream and cash flow can be affected by the
accounting process that is used.

The effect on taxes

Now imagine that the above example took place between November and December of 2017. One of the
differences between cash and accrual accounting is that they affect which tax year income and expenses
are recorded in.

Using cash basis accounting, income is recorded when you receive it, whereas with the accrual method,
income is recorded when you earn it.

Following the above example, using accrual accounting, if you invoice a client for $5,000 in December of
2017, you would record that transaction as a part of your 2017 income (and thus pay taxes on it), even if
you end up receiving the payment in January of 2018.
Further Reading: A Small Business Tax Checklist

Should a small business use cash or accrual accounting?

If your business is a corporation (other than an S corp) that averages more than $25 million in gross
receipts each year, the IRS requires you to use the accrual method.

If your business doesn’t hit those criteria, you’re welcome to use the cash method.

That being said, the cash method usually works better for smaller businesses that don’t carry inventory.
If you’re an inventory-heavy business, your accountant will probably recommend you go with the
accrual method.

To change accounting methods, you need to file Form 3115 to get approval from the IRS.

(If you’re in Canada, the CRA offers guidance on how to change methods here.)

Further Reading: Small Business Accounting 101: A Guide for New Entrepreneurs

There are two accounting methods that companies can choose from when deciding how they want their
books done. They are cash basis and accrual basis. In this lesson, you will learn the differences between
the two.

All About Timing

Have you ever been in the wrong place at the wrong time? Or what about being at the right place at the
right time? The one thing that is similar among both scenarios is timing. Timing is everything, and in
accounting, it is the one major difference between cash-basis and accrual-basis accounting. How is that
you wonder? Well, let's look a little deeper into the concepts of cash- and accrual-basis accounting, and
you can see for yourself.

What Is Cash-Basis Accounting?

My momma always told me that you never count your chickens before they hatch. It took me years to
understand exactly what she meant, but I finally did. She meant to never count on anything until it was
in your hand.

In a sense, that is exactly what cash-basis accounting is. The literal definition of cash-basis accounting is
the accounting system that recognizes cash when it is received and bills when they are paid.

As you can see, the chickens aren't counted until they hatch! This is the way that most of us handle our
personal finances, but is it the best way for a business to operate?

What Is Accrual-Basis Accounting?

The accrual basis of accounting is just the opposite. In this form of accounting, you do count your
chickens before they hatch! In the accrual form of accounting, revenue is recognized when it is earned
and expenses when bills are received, regardless of when cash changes hands.

In reality, this is the form of accounting most used by businesses. Why would that be? Simply because
the accrual form of accounting paints a better financial picture of what a company is really valued at by
recognizing and recording income and expenses regardless of whether cash has been received or paid
out.

Differences Between the Two

The main difference between these two forms of accounting goes right back to timing. Of course, timing
has a partner here. It is called revenue recognition. Cash basis only records revenue when cash is
received and not a moment before. It also only recognizes an expense when cash has been paid out. So,
even if a bill is sitting on your desk, if it has not been paid, it is not considered an expense in cash basis
accounting - at least not until you write a check to pay that bill.

In the accrual basis, revenue is recognized when it is earned and not when it is received. Expenses are
recognized when bills are received regardless of when they're paid.

Another pretty important difference in these two forms of accounting is how well cash is tracked. Cash-
basis accounting does an excellent job of tracking cash flow because it records the inflows and outflows
only when they occur. However, it does a horrible job of matching revenues and expenses in the
accounting period that they occur.

Accrual basis does an excellent job of matching revenues and expenses and a poor job of tracking cash
flow because it recognizes income before it is received and expenses before they're paid.

A third example of differences between these two types of accounting methods is this: in order for a
company to use cash-basis accounting, it can't sell items using in-house charge accounts that would
result in an account receivable. It must only accept cash, check or credit cards as payment. Under the
accrual basis of accounting, the company does have accounts receivables.

Small business owners are often confused about the difference between cash and accrual basis
accounting. This might sound like something that an accountant should show but this information is
useful for business owner as well. In this article, we’ve explained how each of these accounting methods
work. Find out more which accounting method is best for your business.
Introduction to Cash method

Cash method is an accounting system that identifies income (or revenue) only when payment is
accepted and expenses only when payment is done. The cash method is straight forward in sense that
the business’s books are maintained on the basis of the real flow of cash in and out of the business. In
this case, income is logged as soon as it is received, and expenses are reported when they are truly paid.

The cash method is implemented by several sole proprietors and trades with no inventory. The cash
basis is generally practised by small companies and users because it is comparatively easier and less
costly. Cash basis accounting does not follow with the rules of generally accepted accounting principles
(GAAP) and it often leaves a time gap between recording the source of an action (purchase or sale) and
its result (disbursement or receipt of money).

If in certain situation, a client pays you in advance, cash accounting method permits you to account for
those funds on your income statement when they are accepted instead of waiting till you truly earn
them. Cash method also offers a lot of inventive freedom to handle what you own in the bank to suit
your own style of accounting and context at any time. This makes the accounting process easier for
tracking internally.

Introduction to Accrual method

The accrual method of accounting is the theory of recording revenues when received and expenses as
gained. Accrual method of accounting is the normal approach to recording and maintaining transactions
for businesses. This method logs revenues on the income statement when they are received even if the
client will pay after period of 30 days. In the situation when the revenues are earned the business will
credit a revenue account and will also debit the asset account Accounts Receivable. In this case, when
the customer pays after 30 days passed when the revenues were earned, the company will debit cash
and will also credit Accounts Receivable.

The accrual method of accounting is supported under both generally accepted accounting principles
(known as GAAP) as well as international financial reporting standards (known as IFRS). These
accounting frameworks offer sufficient guidance on how to account for revenue and expense
transactions in the devoid of the cash receipts or expenses that would activate the recordation of a
business under the cash base of accounting.

In terms of accounting, the accrual method and the related adjusting entries will outcome in a complete
and precise reporting of a company’s properties, equity, liabilities, and remunerations during all
accounting process.

The profit of accrual accounting is perceived as more precise measure of a company’s productivity.
Businesses are mandatory to apply the accrual basis when they comply with GAAP. The accrual method
efforts to match the income received from a contract to the expenses incurred to that contract. Because
of this, contractors repeatedly have to change their accrual methods through the lifespan of their
business. This method applies chiefly to small contractors, though smaller entities may also apply
methods such as the exempt percentage of completion method (known as EPCM) or completed contract
method (known as CCM).

Example Of Cash Basis And Accrual Basis Accounting:

The difference between cash method and accrual method can be easily understood to you from few
examples explained below:

For example, if you initiate an accounting service in month of December and offer INR 6 lacs of
accounting services in December, but have not received any of the money from the customers till
January, there will be an alteration in the income statements for December and January in the cash and
accrual bases of accounting. Under the accrual method, your income statements will display INR 6 lacs
of revenues in December and nothing of those services will be stated as revenues in January. Under the
cash method, your income statement of December will display no revenues. In its place, the December
services will be recounted as January revenues under the cash based method of accounting.

In above case, you will also find a difference on the balance sheet. In the accrual method, the balance
sheet of December will report accounts receivable of INR 6 lacs and the assessed true profit will be
supplemented to vendor’s equity or reserved earnings. In the cash method, the INR 6 lacs of accounts
receivable will not be stated as an asset, in that case the true profit will not be encompassed in vendor’s
equity or retained earnings.

There is another example of both these methods explained here. Your computer installation business
completes a work in November, and doesn’t get remunerated till three months later in January. In the
cash method, you would record the payment in month of January while in the accrual method you
would record the revenue in your November books.

When to use Cash method in your business

Basically you need to use Cash method of accounting when cash actually changes hands. This means
that it is used when cash payment is gained by the company from clients or paid out by the company for
procurements or other services. You can use it when cash receipt or payment is to be made in the
system of check, cash, credit card, electronic transfer, or other system used to pay for an item.

You can avoid using Cash-basis accounting if a store vends goods on store credit and bills the customer
at a future date. There is no facility to record and track cash due from customers at a particular time in
the future in this accounting method.

It is a pronounced option for personal businesses, independent contractors, and self-employed

employees. The cash basis is only accessible for use if a business has no higher than INR 33 crore of sales
for a year. It is simplest to accomplish transactions using the cash basis, as no complicated accounting
transactions such as deferrals and accruals are compulsory.

When to use Accrual method in your business

The accrual method is used when it is required to be tax compliant. In such cases it is used when
businesses that have additional of INR 33 crore in gross sales revenue.
The accrual method of accounting is more preferred when,

A more comprehensive reporting of the company’s properties, liabilities, and stockholders’ equity at the
termination of an accounting period is required,

A more accurate reporting of a company’s incomes, expenditures, and net income for a precise time
interval based on a monthly, quarterly or yearly basis is required.

This method is used when it is required to have tax reporting when sales surpass INR 33 crore. Also, a
business’s financial statements can only be reviewed if they have been equipped using the accrual
method. It is also used when the financial results of a business are more probable to match incomes and
expenditures in the identical reporting period, in order that the accurate profitability of a business can
be recognised.

Concluding Note

Cash method and accrual method are accounting methods that vary depending on the timing of when
expenses and revenues are predictable. When a company implements cash method accounting, it
identifies revenues when cash is essentially earned and expenses at the time they are paid. Using
accrual accounting, income is predictable at the time revenue is gained (which may not occur when it is
gained) and expenses are logged when liabilities are acquired (which may not occur when they are
funded).

With simple accounting software like ProfitBooks, you don’t need to worry about the accounting
principles. ProfitBooks smartly hides all the complexity and gives you a simple interface to enter your
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Accounting: An Overview

The main difference between accrual and cash basis accounting lies in the timing of when revenue and
expenses are recognized. The cash method is a more immediate recognition of revenue and expenses,
while the accrual method focuses on anticipated revenue and expenses.

KEY TAKEAWAYS

Accrual accounting means revenue and expenses are recognized and recorded when they occur, while
cash basis accounting means these line items aren't documented until cash exchanges hands.
Cash basis accounting is easier, but accrual accounting portrays a more accurate portrait of a company's
health by including accounts payable and accounts receivable.

The accrual method is the most commonly used method, especially by publicly-traded companies as it
smooths out earnings over time.

Accrual Accounting Method

Revenue is accounted for when it is earned. Typically, revenue is recorded before any money changes
hands. Unlike the cash method, the accrual method records revenue when a product or service is
delivered to a customer with the expectation that money will be paid in the future. Expenses of goods
and services are recorded despite no cash being paid out yet for those expenses.

Cash Basis Accounting

Revenue is reported on the income statement only when cash is received. Expenses are only recorded
when cash is paid out. The cash method is mostly used by small businesses and for personal finances.

Key Differences

The key advantage of the cash method is its simplicity—it only accounts for cash paid or received.
Tracking the cash flow of a company is also easier with the cash method.

But a disadvantage of the cash method is that it might overstate the health of a company that is cash-
rich but has large sums of accounts payables that far exceed the cash on the books and the company's
current revenue stream. An investor might conclude the company is making a profit when, in reality, the
company is losing money.

Meanwhile, the advantage of the accrual method is that it includes accounts receivables and payables
and, as a result, is a more accurate picture of the profitability of a company, particularly in the long
term. The reason for this is that the accrual method records all revenues when they are earned and all
expenses when they are incurred.
For example, a company might have sales in the current quarter that wouldn't be recorded under the
cash method because revenue isn't expected until the following quarter. An investor might conclude the
company is unprofitable when, in reality, the company is doing well.

The disadvantage of the accrual method is that it doesn't track cash flow and, as a result, might not
account for a company with a major cash shortage in the short term, despite looking profitable in the
long term. Another disadvantage of the accrual method is that it can be more complicated to implement
since it's necessary to account for items like unearned revenue and prepaid expenses.

Special Considerations

The accrual method is most commonly used by companies, particularly publicly-traded companies. One
reason for the accrual method's popularity is that it smooths out earnings over time since it accounts for
all revenues and expenses as they're generated instead of being recorded intermittently under the cash-
basis method. For example, under the cash method, retailers would look extremely profitable in Q4 as
consumers buy for the holiday season but would look unprofitable in Q1 as consumer spending declines
following the holiday rush.

Both methods have their advantages and disadvantages, and each only shows part of the financial
health of a company. Understanding both the accrual method and a company's cash flow with the cash
method is important when making an investment decision.

Accrual Accounting vs. Cash Basis Accounting Example

Let's say you own a business that sells machinery. If you sell $5,000 worth of machinery, under the cash
method, that amount is not recorded in the books until the customer hands you the money or you
receive the check. Under the accrual method, the $5,000 is recorded as revenue immediately when the
sale is made, even if you receive the money a few days or weeks later.

The same principle applies to expenses. If you receive an electric bill for $1,700, under the cash method,
the amount is not added to the books until you pay the bill. However, under the accrual method, the
$1,700 is recorded as an expense the day you receive the bill.

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Related Terms

Cash Cost

Cash cost is a term used in cash basis accounting (as opposed to accrual basis) that refers to the
recognition of costs as they are paid in cash. more

Operating Cash Flow (OCF) Definition

Operating Cash Flow (OCF) is a measure of the amount of cash generated by a company's normal
business operations. more

Accrued Expense Definition

An accrued expense is recognized on the books before it has been billed or paid. more

What Is Accrual Accounting and Who Uses It?

Accrual accounting is an accounting method that measures the performance of a company by

recognizing economic events regardless of when the cash transaction occurs. more

Financial Accounting

Financial accounting is the process of recording, summarizing and reporting the myriad of a company's
transactions to provide an accurate picture of its financial position. more

Cash Basis

Cash basis is a major accounting method by which revenues and expenses are only acknowledged when
the payment occurs. Cash basis accounting is less accurate than accrual accounting in the short term.
more.