Cash Basis vs. Accrual Basis

Cash accounting or accrual accounting is the most common method of tracking income and expenses. However, depending on your business model, either approach may be preferable. You need to determine the best Accounting Finance practices and ensure your business model meets government requirements. For example, the Tax Reform Act of 1986 prohibits certain businesses from using cash accounting.

To choose the right accounting method, you need to understand the main differences between them.

Cash-based accounting:

This method focuses on the company’s cash flow, tracking money coming in as income or going out as expenses.

Accrual accounting:

This approach takes place whenever an action generates revenue or incurs an expense.

The main difference between the two approaches is timing. In cash accounting, you record when you receive income and when you pay expenses. However, under the accrual basis, income is recognized when you owe it, and expenses are recognized when you owe it. It doesn’t matter when the money is in and out of your account. This is important because sending and receiving payments is not always instantaneous.

This article explains how cash and accrual accounting work, the pros and cons of each, which software tools are best for each option, and which accounting method is best for which type of business.

What is cash basis accounting?

Cash accounting is also called cash receipts and payments or cash accounting. The system emphasizes cash flow, with a particular emphasis on cash on hand. Maintaining profitability is critical for start-ups and very small businesses. Knowing exactly how much cash you have available helps you determine when and how quickly your bills will be paid.

When should you use cashier-based accounting?

Certain types of businesses can take full advantage of this form of accounting. For example:

Sole Proprietors and Small Businesses:

These businesses are more likely to use cash accounting that is simple and easy to use. In addition, their income tends to be well below the $25 million annual limit, so the system cannot be used to calculate income tax.

Companies that operate without inventory:

Companies are required to account for inventories at the beginning and end of the tax year. This problem arises because cash accounting focuses on the flow of money rather than tracking the movement of inventory. However, businesses that are short on inventory should be content with cash-based accounting. In addition, small businesses that meet the $25 million cap will be allowed to treat inventory as supplies and non-accumulated materials.

Cash transactions:

Although less common these days, some companies do not accept debit or credit cards. These companies probably don’t have to worry about credit-related debt.

Cash basis for corporate tax, etc.

The use of cash payment methods for income tax is popular with businesses for two main reasons. First, this method of Accounting Firm makes it easy for businesses to answer questions about annual income, expenses, and financial losses. It also makes it easier for businesses that focus on incoming cash flow to align earnings with key dates, making it easier to pay taxes on time.

The Downside to the Cash Method of Accounting

Although the cash basis method of accounting has advantages, it also has significant disadvantages.

Because it monitors cash flow, not reserves, it’s not always possible to know exactly when a company is making money or paying expenses. Without accounts receivable and payable records, it is even more difficult to accurately determine the current financial situation of a company, and this can lead to significant discrepancies.

There may be inaccuracies regarding assets or liabilities. With purely cash-based accounting, important information about outstanding invoices and company liabilities can be lost. This can also result in the unintentional omission of certain assets. Cash accounting works well for many small businesses. However, if you have concerns about the health of your business or important details other than cash flow, you should choose a different method of accounting.

best cash accounting software

Luckily, there are so many ways to keep your financial records clear that businesses of all sizes no longer have to do it manually. We have the best accounting services and software options for cash accounting.

FreshBooks is an accounting software service with affordable tiered options aimed at freelancers and small businesses. This allows you to send invoices and receive payments quickly. FreshBooks provides all the essentials through a simple and intuitive design. For more information, read our in-depth review on FreshBooks.

What is accrual accounting?

In accrual accounting, income is recorded when it is earned, and expenses are recorded when incurred. The system uses accounts payable and accounts receivable to provide an accurate, real-time view of a company’s financial situation.

Accounts payable:

Money, a company owes to a supplier or creditor.

Requirements:

Money owed by a business for services rendered.

Businesses that use accrual accounting methods to accurately track their accounts payable and receivables keep their books according to the current status of the invoice or invoice. For example, if you have a long-term relationship with a particular customer, there will be documentation that indicates when the service was provided, when the invoice was issued, and when the invoice was paid. The same applies to our ongoing relationships with our suppliers. These documents will tell you when you will receive payment and which invoices are outstanding. You can also see which invoices your company has already paid and which expenses and liabilities you still have to pay. Using this method, you can easily keep up to date with the individual status of each sale or invoice, reconcile each item as it is fulfilled, or take notes on pending ones.

Therefore, accrual accounting methods ultimately provide a more accurate picture of a company’s financial position and consider much more than just cash flow and cash on hand.

When To Use Accrual-Basis Accounting

Larger companies tend to have too many variable financial components to rely on a simpler cash-based approach, so accrual accounting is often a must. Here are some examples of where the accrual method works best.

When accepting or making credit card payments:

Cash payments can be settled relatively quickly, but credit-based payments take longer to complete. Moreover, such payments can be made days or weeks after the initial transaction.

Asset and Liability Tracking:

In addition to cash on hand, businesses also include checks, short-term deposits, and inventory as assets. Similarly, unpaid expenses are liabilities recognized before the invoice is paid, not after the payment is sent. Accrual accounting makes it easier to distinguish between assets and liabilities by keeping up-to-date records of which items fall into which category in which period.

Ensuring GAAP compliance:

US publicly traded companies must comply with Generally Accepted Accounting Principles (GAAP) promulgated by the Financial Accounting Standards Board (FASB). Therefore, a company like this must use accrual accounting as it complies with its GAAP standards.

Additionally, accrual accounting provides a complete and accurate picture that cannot be manipulated. It is easy to misjudge a company’s financial health by judging a company by when cash becomes available and when it is disbursed. An accrual-based approach requires that everything be settled in a timely manner.

Disadvantages of accrual accounting

Although accrual accounting is a highly trusted and preferred form of accounting, accrual accounting has the following drawbacks:

1.It’s very complicated. Accrual accounting requires more detailed records. Even with the right software, business owners new to this kind of accounting can find it difficult to use at first.

2.It can take a lot of time and money. Maintaining an annual set of documents and regularly checking for changes and updates can be time-consuming. As your business grows, you may need to outsource the maintenance of business records and the updating of software tools.

Ultimately, this method can be expensive, time-consuming, and difficult for small businesses to use.

Best accrual accounting software and services

As your business grows in size and complexity, you need to be ready to move to accrual-based software and services. For example, you can use Intuit’s QuickBooks Online to move from cash accounting to accrual accounting. This subscription-based service helps you track bills, expenses, employee hours worked, and more. Working with an accountant makes it easy to share spreadsheets to get an accurate picture of your finances and tax obligations.

Comparison of cash accounting and accrual accounting

The main difference between cash accounting and accrual accounting is attributed to her three factors:

Timing, Complexity, and Responsibility. Cash-based approaches are easy to apply but often do not provide a complete picture of a company’s finances. On the other hand, the accrual method requires a more thorough approach that allows you to easily get a complete financial picture of your business and its current health.

Simplicity works well for individuals and very small businesses, but not so much when your business is growing. Therefore, for small businesses, it may make sense to start with a cash-based approach and switch when the business requires greater responsibility.

Conclusion

Both accrual and cash basis accounting have their advantages and disadvantages. A company may choose one system over the other for logical reasons such as company size and budget. If you are unsure which approach is best for your business, we recommend seeking professional advice to determine whether you should use cash accounting or accrual accounting.