Cash vs. Accrual Accounting: What’s the Difference?
There’s more to accounting than keeping a record of your transactions! Accounting provides a snapshot of your business’ assets and liabilities. It also allows you to budget, plan, make important financial decisions, and assess the overall performance of your company.
But the decision isn’t so cut and dry! There are two primary accounting methods: cash basis accounting and accrual basis accounting. So, how do you know which one works best for your business?
In this article, we’re going to be taking a look at the difference between cash and accrual accounting. We’ll cover the benefits and disadvantages of the two methods, and by the end of this article, you should have a clearer picture of whether cash or accrual accounting best suits your needs.
NOTE: FreshBooks Support team members are not certified income tax or accounting professionals and cannot provide advice in these areas, outside of supporting questions about FreshBooks. If you need income tax advice please contact an accountant in your area.
The Cash Method
With cash basis accounting, income and expenses are recorded as they are paid. This means that you only account for them when cash is received—i.e., the moment cash arrives in your hands (or your bank account)—and you only account for outgoing funds once you make payments. Any unsettled invoices or unpaid bills are not recorded until they are completed.
So, for example, if you invoice a client for $500 in February 2019 but they don’t pay you until June 2019, the revenue is recorded under June, not February.
Because it’s a pretty simple and straightforward method of accounting, cash accounting is preferred by small business owners and those tracking their personal finances. However, as per the Internal Revenue Service (IRS), businesses that “produce, purchase or sell merchandise” are required to keep an inventory and use accrual basis accounting to record sales and purchases of merchandise (i.e., not cash basis accounting).
Pros of Using Cash Accounting
- It’s simple and easy. The cash method is pretty straightforward, as there is no need to keep track of things like accounts receivables and accounts payables. Just like in tracking your personal financial records, cash accounting is as easy as listing revenue and expenses as you receive/spend them.
- It doesn’t put a huge dent in your income tax expense. With cash accounting, you only have to pay taxes on revenue received within a particular month. This means that you don’t have to pay taxes for any delayed revenues, generating better cash flow for your company.
- It gives you a daily record of your business’ financial status. Cash basis accounting gives you a day-to-day snapshot of where you’re at financially.
Cons of Using Cash Accounting
- Cash basis accounting leaves you with no record of accounts payable and receivables. Without a record of what you’re owed and what you owe, you don’t have the complete picture of your financial status. For example, if you have yet to pay your bills for the month, cash basis accounting could lead you to believe that you have more money than you actually do.
- It doesn’t help you make long-term decisions. Without a clear understanding of how much customer/client debt affects your profits, you cannot make the necessary changes to improve the way you do business.
- It cannot be used once your company grows past $25 million in annual sales. According to the IRS, corporations earning over $25 million per year must use the accrual accounting method. When your company grows, you’ll have to reacquaint yourself with a new accounting method.
The Accrual Method
In contrast to the cash method, accrual basis accounting entails recording revenue once an invoice is made and recording expenses once you’re charged. This means that you make a record of income even before it reaches your bank account, and you note deductions for bill payments and the like before they’re paid.
With the accrual method, you make use of an accounts receivable and accounts payable record in your books. An accounts receivable is money owed to you by a client or a customer for your services, while an accounts payable is money you owe another business, like your utilities provider or materials supplier.
So, for example, if you send an invoice for $200 on May 2019 but receive the money in October 2019, you make a record of that $200 accounts receivable in May 2019.
Pros of Using Accrual Accounting
- It provides a more realistic, long-term picture of your finances. With a more detailed report of your cash flow, the accrual method enables you to make projections for your revenue stream in certain months, make contingencies for dry spells, and even pinpoint clients/customers who delay payments.
- It makes it easier to score investors. When you have a better understanding of your financial situation—and you have solid evidence that your business is profitable—it’s easier to convince investors to take a chance on your company.
- There is no need to change accounting methods when your business grows. The accrual method is the required accounting method for businesses that make over $25 million a year. Starting with the accrual method saves you the hassle of making the switch (which you can’t do mid-year, by the way).
Cons of Using Accrual Accounting
- It’s tedious, time-consuming work. If you’re the head of your company and you’re handling bookkeeping too, keeping up with accounting accrual might prove to be too much work. For this, it might be wiser to hire a dedicated accountant.
- The accrual method can give you a false sense of financial security. Because you’re recording invoices that haven’t been paid yet, you can trick yourself into believing there is already money in the bank.
- It puts you at risk of paying taxes for income before cash is received. If a customer or client hasn’t paid before you must file taxes, you may end up having to shoulder the cost of income tax.
Which Accounting Method Is the Best Choice for a Small Business?
For freelancers and small business owners, whether to choose the cash vs. accrual method of accounting comes down to considering the pros and cons. The cash method is an easy and familiar bookkeeping method for keeping track of your monthly income and expenses. However, it doesn’t give you the full view of your finances. And if you want your business to grow in the next few years, it would be a smart move to learn the accrual method.