When it comes to managing the books of your business, one of the most important decisions you need to make is which accounting method to use. Luckily there are just two options: cash-basis accounting and accrual accounting.
With cash-basis accounting, the moment that you pay a bill or receive a check from a customer, you need to record that sale and purchase, respectively. However, for accrual basis accounting, it does not matter when you get paid from your customer or when you pay your vendor; a sale counts as soon as you have provided the service or product and an expense counts as soon as you have received your goods or services from your vendor.
In this article, we will compare the accrual vs cash methods as follows:
- What Is Cash-Basis Accounting
- What Is Accrual Accounting
- Cash-Basis Accounting: Pros & Cons
- Accrual Accounting: Pros & Cons
- When to use Accrual Accounting
What Is Cash-Basis Accounting?
If you decide to go with the cash-basis accounting method, which is what most small businesses use, that means you will record sales and purchases when cash changes hands. Let’s take a look at a couple of examples to see how you would handle sales and purchases using the cash-basis method:
Sales Example (Cash-basis method)
Let’s say that you provided 3 hours of consulting for a client and you will create an invoice to bill that client for those hours. Under the cash-basis method, this sale should not be recorded on your books until you receive payment from your customer. (when cash changes hands)
Purchases Example (Cash-basis method)
Let’s say that you purchased a printer and a couple of laptop computers for your office. You ask the vendor to overnight them to you, however, the vendor bill does not arrive for 2 more days. Using the cash-basis method, this purchase is not recorded on your books until you actually pay the vendor. (when cash changes hands)
What is the Accrual Accounting Method?
If you go with the accrual accounting method, you will record sales and purchases as soon as the services have been fulfilled or the products have been received. Let’s go back to our previous examples to see how they would work using the accrual accounting method.
Sales Example (Accrual method)
Let’s say that you provided 3 hours of consulting for a client and you will create an invoice to bill that client for those hours. Under the accrual method, this sale should be recorded on your books immediately because you have provided the services. It does not matter when your customer actually pays you; this is considered a sale using the accrual method.
Purchases Example (Accrual method)
Let’s say that you purchased a printer and a couple of laptop computers for your office. You ask the vendor to overnight them to you, however, the vendor bill does not arrive for 2 more days. Using the accrual method, this purchase should be recorded on your books immediately because you have received your products. It does not matter when you actually pay for them.
Accrual-based accounting can be a bit more difficult to track unless you use an accounting software program like QuickBooks. You can invoice customers, pay bills and always have up to date reports to help you keep track of all unpaid customer invoices and vendor bills. Another benefit of using QuickBooks is that you can run reports and select the option to produce reports based on both the cash or accrual accounting methods at anytime!
Cash-Basis Accounting: Pros & Cons
As mentioned previously, most small businesses use the cash-basis accounting method. Let’s discuss in more detail some of the pros and cons of using cash-basis accounting:
Pros to Using Cash-Basis Accounting
1. Easy to use
For most people who don’t have an accounting background, the cash basis makes perfect sense. With this method, a sale does not count until you have received payment from your customer; a purchase does not count until you have paid for the products or services purchased. In a nutshell, transactions count only when cash has changed hands, and that makes makes this method very easy to understand.
2. Tracks cash flow
The cash-basis method is all about cash flow in (sales made to customers) and cash flow out (purchases made from suppliers). Using this method, makes it easy to keep track of your cash flow so that you don’t run into a cash shortage.
3. Lower tax bill in Certain Scenarios
Since sales don’t count until you have received payment from your customers, you could potentially end up with a lower tax bill. For tax purposes, you will generally pay taxes on the net earnings (profit) for your business. The less income (sales) that you have to report, the lower your net profit will be, which means a lower tax bill.
For example, let’s say that you had total sales of $50,000 for the year. However, you only received payment of $40,000. As a business that uses the cash-basis method, you would only report sales of $40,000 since that is all the “cash” you received. After you subtract your business expenses, you would owe taxes on the bottom line net profit, if any. In this example, you are going to pay less taxes than you would have if you reported $50,000 in sales.
While you can’t control when you get paid, you can control the amount of money that you spend. If you decide to make a few big purchases for your business before the end of the year, this could also result in a lower tax bill since you could potentially deduct these expenses on your tax return.
Cons to Using Cash-Basis Accounting
1. No matching of revenue vs. expenses
The cash basis method does not accurately match revenue earned with the money that was paid out for expenses. This can be a problem if you purchase products in one month and sell them in the following month.
For example, let’s say that you purchased $5,000 in product in the month of February with plans to sell the products to your customers. However, you don’t sell any of the items until March.
As a result, when you close the books in February, you have a huge expense of $5,000 with no revenue to offset it so you report a loss in February. For the month of March, you sold the products for a total of $6,000.
As a result, when you close the books in March, you have a profit of $6,000. When you run your profit and loss reports it will appear that the month of February was bad (loss of $5,000) and the month of March was good (profit of $6,000) when in actuality you had a net profit of $1,000 over the two months.
2. Not acceptable by banks
If you are looking to get approved for a business line of credit or loan then you will need to provide the bank with financial statements that are based on the accrual accounting method since generally that is what they prefer. The good news is, if you use QuickBooks you can produce financial statements using either cash or accrual method.
3. Higher Tax Bill in Certain Scenarios
Since expenses do not count until you have paid them (under the cash basis method), you cannot deduct any expenses that have not been paid on your tax return which could result in a larger tax bill. As discussed previously, you pay taxes on the net earnings (profit) from your business. The fewer expenses you have to offset income, the higher your bottom line profit will be; which means a higher tax bill.
Accrual Accounting: Pros vs. Cons
The accrual accounting method is commonly used by businesses that keep inventory and have gross sales over $5 million dollars. Let’s discuss in more detail some of the pros and cons of using the accrual accounting method.
Pros to Accrual Accounting
1. Visibility to all Sales and Purchases
With the accrual accounting method, all sales and purchases are recorded when they occur, even if cash has not changed hands. This helps you to easily track the money that is owed to you (commonly known as accounts receivable) and the money that you owe to your vendors/suppliers (known as accounts payable). You can learn more about accounts receivable and accounts payable here.
2. Matching of Revenue and Expense
Unlike cash-basis accounting, the accrual method does a much better job of matching revenue earned to money paid out for expenses. For example, let’s say that you purchased $3,000 in products in June to sell to your customers. Let’s say that you sold all of those items for $4500 to several customers. You have shipped the products but you have not received payment from any of your customers yet.
Under the accrual method of accounting, you would show sales of $4,500 and expenses of $3,000 which would result in a net profit of $1500 ($4500 – $3000) for the month of June. Since sales and purchases count immediately, you can record them on your books immediately and show the actual profit made for the month of June.
3. Lower Tax Bill in Certain Situations
When it comes to the accrual method, expenses count as soon as you have received products and/or services that you have purchased, regardless of whether or not you have paid for them. This can work in you favor because you may be able to deduct expenses from your taxes even though you have not paid for them.
For example, let’s say that you decide to splurge and buy all of your sales reps an iPad that they can use instead of travelling with a heavy laptop computer. You order the iPads on your account with Apple and you receive them on Dec 24 but you do not get a bill until January 1. Under the accrual method, the iPads count as an expense because you received them in December. Therefore, you can write them off as a tax deduction even though you have not paid for them yet.
Cons to Accrual Accounting
1. Harder to use
The accrual method is not as simple to use as the cash method of accounting. As mentioned previously, you must use an accounting software program like QuickBooks to help you keep track of your cash flow. By creating customer invoices in QuickBooks and entering your vendor bills, you are able to run reports anytime to see who owes you money and who you owe money to.
2. Must use cash flow statement to keep track of cash flow
The accrual method of accounting does a poor job of tracking cash. Since you record revenue when the transaction is complete and not when you collect the cash from your customers, your income statement could reflect a large amount of income even if you don’t have cash in the bank. This will require you to use the cash flow statement so that you can keep track of the actual cash in and out of your business. You can watch our video tutorial to learn more about the cash flow statement and how to run one in QuickBooks here.
For example, let’s say that you are running a consulting business and your days are filled with client appointments. You send your clients an invoice within 24 hours of their consultation that’s due within 30 days. While your income may be high, if you have not received payment from your customers then your bank balance could be low. In addition, if you are so busy that you don’t have time to follow-up with your customers about payment, then you could have some significant cash flow issues.
3. Higher Tax Bill in Certain Scenarios
Using the accrual method of accounting could result in a higher tax bill if your sales are high. Under the accrual method, all sales count as soon as you have provided the services or shipped the products; regardless of whether or not your customer has paid you. For tax purposes, you must include the sale on your tax return even if you have not received payment from your customer when using the accrual accounting method.
4. More Accounts
In order to keep track of outstanding invoices that you have not received payment for or bills that you have not paid, you must use some additional accounts that you normally would not need with the cash basis method.
For example, accounts payable is used to keep track of the money that you owe to your vendors/suppliers. To keep track of your outstanding customer balances, you’ll need accounts receivable. Both of these accounts need to be set up on the chart of accounts. The chart of accounts is a way to categorize business transactions like customer invoices and bills. To learn more about how the chart of accounts works in general, check out our small business accounting guide here.
When To Use Accrual Accounting
As we have discussed so far, most businesses will generally use the cash-basis accounting method to keep their books. However, there are certain situations that may require you to switch to the accrual accounting method. Let’s discuss a few of these scenarios:
1. Annual Revenue exceeds $5 million dollars.
You are eligible to use the cash method of accounting as long as gross revenue does not exceed $5 million dollars. Once you exceed this threshold, you must switch to the accrual accounting method. You are required to file Form 3115 to inform the IRS of your change in accounting method.
2. You carry an Inventory of Merchandise.
If you carry inventory for sale and your gross receipts exceed $1 million dollars, you are required to use the accrual accounting method to record all sales and purchases. This is primarily to ensure that your revenue from product sales is more evenly matched with the cost of that inventory (commonly known as cost of goods sold).
In order to properly calculate the cost of goods sold, you need to use the accrual accounting method. Rather than count the cost of goods the moment you purchase your inventory, as you would with the cash-basis method, you want to record the cost of products as they are sold. In other words, you’ll record the revenue and cost of an item at the same time. This ensures an even match of revenue to expenses.
3. Heavy A/P and A/R.
If you generate a lot of invoices to customers or you have a number of suppliers that you receive bills from, you should consider using the accrual accounting method. It will help you to stay on top of accounts receivable and accounts payable.
If you don’t have a way to track customer invoices and vendor bills, you need to consider using an accounting program like QuickBooks. With QuickBooks, you can set up all your customers with their payment terms. When a customer invoice is coming due, you will receive a reminder so that you can follow-up to ensure timely payment.
Similar to customers, you can also set up your vendors with the payment terms they have extended to you. When your bill is coming due, QuickBooks will remind you to pay the bill. Staying on top of A/P and A/R is critical to maintaining a positive cash flow.
4. Applying for a Business Loan.
As I mentioned previously, banks and financial institutions prefer to have financial statements that are based on the accrual accounting method over the cash-basis method. Therefore, if you plan to apply for a business loan or line of credit, you should consider switching accounting methods so that you can provide financial statements that will meet most bank requirements.
However, if you use an accounting software like QuickBooks, you can actually produce financial statements using either method (cash or accrual) at anytime. This can be a lot more convenient if you are not quite ready to switch from using the cash-basis accounting method. Be sure to check out our free QuickBooks Course. It includes videos plus written instructions so you can be up and running in no time!
The Bottom Line
By now you should have a good understanding of the primary differences between accrual vs cash basis accounting. Remember, you will generally use the cash-basis accounting method unless you fall into one of these groups:
- Your gross receipts exceed $5 million dollars
- You carry inventory and your gross receipts exceed $1 million dollars
- You generate a lot of customer invoices
- You receive a lot of vendor bills
- You plan to apply for a business loan or line of credit