Business owners have two broad accounting methods available to them: the cash basis (aka the cash method) and the accrual basis (aka the accrual method).
The primary difference between the two methods lies in the timing of recording revenues and expenses. Keep reading to learn about how each method works and its advantages so you have a better idea of which method to choose for your business.
The Cash Method
Businesses that use the cash method of accounting to record income when they receive cash and expenses when they pay cash.
Let’s illustrate this with an example.
Say that it’s the 1st of the month. Your business receives a $3,000 check for services you performed for Client X immediately after you perform those services. You also send out a $2,500 invoice to Client Y, due by the 31st.
In this instance, you’d record $3,000 in revenue because you received $3,000 in cash. You don’t include the $2,500 invoice because Client Y has yet to pay it. When they do, you can record $2,500 in revenue.
Continuing on: since it’s the 1st of the month, you pay your $1,000 monthly rent for your office space. Additionally, say you have a credit agreement with a supplier. You receive a $400 invoice in the mail for the inventory you purchased on credit last month.
You’d record $1,000 in expenses since you paid your rent. You’d exclude the $400 invoice from today’s expenses. Once you pay that invoice, you can record the expense.
With all that in mind, you end up with $2,000 in profits.
The Accrual Method
Under the accrual method, you record revenue only when you “earn” it, and expenses only when you “incur” them.
Put another way: you recognize revenue once you perform the services your customer/client paid for. You recognize expenses when you receive a bill or invoice from a supplier or vendor.
Let’s return to the previous example.
Recall that you received a $3,000 check from Client X and sent Client Y a $2,500 invoice. This time, you add Client Y’s invoice to your revenues for a total revenue figure of $5,500.
Now, if Client X had paid you today for an invoice you sent last week, you wouldn’t record their $3,000 as revenue — you already would have when you sent them the invoice.
As for expenses: since it’s the 1st of the month, your landlord provides you the $1,000 rent bill, which you pay and record as an expense. You also record the $400 supplier invoice. Your expenses are $1,400 altogether.
Some quick math shows that your profit is $4,100 under the accrual method.
As you can see, the accrual method is a little more complicated than the cash method. Many people invest in accounting software such as Freshbooks if they choose accrual accounting.
Cash vs. Accrual
Let’s compare the advantages of each method.
The cash method is much simpler: you record transactions when money enters or leaves your hand. There’s no keeping track of transactions that are yet to be fulfilled with cash.
Because of this, simple invoicing software like Square can be enough to do your cash-basis accounting.
The cash method may also offer a minor tax advantage. If you receive an invoice now, you likely won’t have to record it, allowing you to postpone that revenue to a later date. Additionally, you can recognize expenses earlier by paying them faster.
You aren’t cutting your taxes necessarily, but you are delaying them. If the year’s almost over, and you can delay revenues to January 1st, you could essentially defer taxes on that revenue for a year.
Accrual accounting offers some key advantages, despite its more complex nature.
For one, it improves the reliability of your financial information by more accurately representing when you actually earn income and spend capital.
Quick example: stores that see heavy holiday sales (such as a video game retailer) on credit might see a huge revenue spike in January if they use the cash method. This wouldn’t make sense in context. Under the accrual method, they’d recognize those sales when they actually make them (December), which provides better insight into the store’s sales.
Using the accrual method also makes business borrowing easier. Lenders prefer to see accrual-based books due to their better reflection of reality.
Lastly, most businesses have to use the accrual method anyway. The IRS only allows the cash method if you can pass their Gross Receipts rule. In general, only the smallest of businesses can use the cash method.
It’s also worth noting that the Generally Accepted Accounting Principles (GAAP) framework requires accrual accounting for efficiency and reliability purposes.
The Bottom Line
The cash method works well if you’re a solopreneur or small business with simpler finances. You can spend less time worrying about accounting and more time growing your business.
However, the accrual method becomes mandatory at some point, but certain smaller businesses may benefit from it as well. Software like Quickbooks makes accrual accounting a breeze, allowing you to reap the benefits while mitigating the complexity issue.