The option of whether to use the accrual or cash basis of accounting largely depends on what the accounting numbers will be used for as well as the cost and difficulty to produce accrual-basis numbers. Cash-basis accounting is often used for income tax reporting while accrual-basis is usually better for financial statements. The difference between the accrual and cash accounting methods is a bookkeeping fundamental that all bookkeepers should understand.
For small businesses, the primary differences between cash vs accrual accounting are:
Cash-basis | Accrual-basis | |
|---|---|---|
Invoices | Records income when the customer pays the invoice | Records income when a customer is issued an invoice |
Bills | Records an expense when the bill is paid | Records an expense as soon as the good or service is received |
Year-end Adjustments | Doesn’t require adjusting entries because transactions are always recorded upon receipt or payment of cash | Requires many year-end adjustments in the form of journal entries to record expenses incurred but not yet paid, such as rent, utilities, and interest |
Bad Debt Expense | Doesn’t recognize bad debt expense because income isn’t recognized until the cash is received, such as no outstanding invoices to write off | Recognizes bad debt expense for invoices businesses estimate won’t be paid |
Cash Method of Accounting
The cash method recognizes income and expenses when cash is received or paid. This method ignores when the legal obligation occurred. For example, you received a $1,000 bill from a provider for services that were already performed. Upon receipt of the bill, you don’t recognize any expense—you only record the expense when you pay the bill.
Cash Method Is Best for
The cash-basis of accounting is generally preferable to the accrual-basis for filing income tax returns. This is because the cash-basis of accounting aligns income with cash received. Thus, companies with high income are more likely to have cash flow available to pay taxes.
Another advantage of cash-basis accounting for income taxes is that it is easier to control the timing of your tax deductions since expenses are deducted when actually paid. For example, if you prefer a tax deduction in the current year, the expense can be paid at the end of December. If you prefer the deduction next year, wait to pay the expense until January.
Tip:
Not all businesses can use the cash-basis on their tax returns. However, C corporations (C-corps) with less than $25 million in average gross receipts for the past three years, S corporations (S-corps), and partnerships are generally allowed to use the cash method.
Advantages of the Cash Method of Accounting
- Requires little accounting expertise: The cash method is common sense. When you receive cash, you record it as income. Otherwise, cash payments are expenses. The cash method doesn’t require you to have in-depth accounting knowledge because you only track the cash flow.
- Focuses more on cash flow generation: The cash method provides more information on your business’ ability to generate cash. By tracking cash flow, you can assess if the business is generating enough cash to cover cash payments at a given period. With the accrual-basis, you must generate a separate statement of cash flow to get this information.
- Uses simplified accounting: If you connect your bank account to an accounting software program, bank feeds record all your cash transactions in the system automatically—you don’t need to record these transactions manually.
- Requires simplified financial reporting: The cash-basis income statement replaces the cash flow statement under the cash method. Since all revenues and expenses are recorded when cash is received or paid, the net income is also the net increase in cash during the period.
Accrual Method of Accounting
The accrual method recognizes income and expenses when earned or incurred. Accounting standards of the United States generally accepted accounting principles (GAAP) mainly use this method, especially when dealing with complex accounting transactions like foreign currency translations, hedging, and investment accounting.
To illustrate, let’s assume your business received an electric bill for the month of July, and its due date is on August 10. Under the accrual method, you need to recognize the utility expense in July because the electricity consumption is for the month of July. Hence, accrual records must debit utilities expense and credit utilities payable.
Accrual Method Is Best for
The accrual-basis of accounting is preferable to the cash-basis of accounting for preparing financial statements to be used by management, bankers, or investors. Accrual-accounting gives a better picture of the profitability of a company because it generally recognizes revenue in the same period as the expenses to produce that revenue. For this reason, companies that must comply with GAAP are required to use accrual accounting.
QuickBooks Online can produce either cash or accrual financial statements from the same set of books. If your software cannot do this, you should keep your books on the accrual basis. An accountant can then convert your accrual basis statements to cash basis if it’s needed for a tax return.
Since accrual accounting is more difficult, it’s not suitable for some small businesses, and the cost of implementing an accrual-basis accounting system might outweigh the benefits.
Advantages of the Accrual Method of Accounting
- Provides detailed, timely, and relevant accounting information: The accrual method matches revenues and expenses because transactions are recorded at the date earned and incurred, not the payment date. You can easily match expenses incurred to generate revenues and determine the profit from transactions.
- Focuses more on profitability: The accrual method highlights profitability because it matches revenues and expenses. It shows your profit based on revenues and expenses belonging to the same period.
- Uses complex accounting: Accrual accounting requires you to record invoices and bills upon receipt. You also need to make year-end adjustments for accruals and deferrals to update the balances of accounts. However, small business accounting software like QuickBooks Online makes accrual accounting easy with its easy invoicing and bill tracking.
- Requires comprehensive financial reporting: Under accrual accounting, you need to generate the four basic financial statements: income statement, statement of owner’s equity, balance sheet, and statement of cash flows. The income statement can give you information about the business’s profitability, while the cash flow statement shows your business’s ability to generate cash flows. The statement of owner’s equity shows movement in the capital accounts, whereas the balance sheet shows the business’s financial position at a point in time.
Example of Cash-basis vs Accrual-basis Accounting
- December 15, 2022: Receives bill for contract labor of $1,000
- December 17, 2022: Invoices customer $3,000 for labor
- December 20, 2022: Pays bill of $1,000
- December 31, 2022: Owes $300 interest on loan
- January 5, 2023: Receives payment from customer of $3,000
- January 5, 2023: Pays $300 interest
ACCRUAL | CASH | |||
|---|---|---|---|---|
2022 | 2023 | 2022 | 2023 | |
Revenues | $ 3,000 | $ - | $ - | $ 3,000 |
Expenses: Contract labor Interest | (1,000) (300) | - - | (1,000) - | - (300) |
Net income (loss) | 1,700 | - | (1,000) | 2,700 |
TOTAL NET INCOME | $1,700 | $1,700 | ||
Notice that the total net income for all periods under the accrual-basis and cash-basis is the same. Because of timing differences, both methods of accounting yield different net income per accounting period. Even if the cash-basis net income yielded a $1,000 net loss in 2022, the same method reported a net income of $2,700 in 2023 while 2023 accrual net income is zero. But if you offset the 2022 net loss to the 2023 net income, the overall two-year income is $1,700.
Bottom Line
Cash vs accrual accounting isn’t an argument of which method is better. Rather, it’s a business decision grounded on how the information will be used and the difficulty in producing accrual-basis financial statements. Many businesses will use the cash-basis for income tax returns and the accrual-basis for financial reporting. However, some very small businesses will produce cash-basis financials because accrual-basis accounting is too complex and difficult to apply.
