The difference between cash and accrual accounting lies in when money is recognized as having come into or left the business.
Cash basis accounting recognizes revenue or expenses at the moment cash is received or paid.
Accrual basis accounting, on the other hand, recognizes revenues and expenses when they’re earned or incurred, regardless of when cash is received or paid.
In other words, accrual accounting recognizes payment on the day the invoice is sent, while cash accounting recognizes it on the day the money is deposited.
Many businesses start out using cash accounting practices because it’s simpler to implement and understand. At any point, it is easy to track the amount of cash on hand and plan for upcoming payments because the books reflect accurate account balances.
That said, because it does not take into account future payments or earnings, it presents an unsteady view of the business and makes it easier to overstate or understate the health of the business. For example, if sales are strong in June but several payments are due the first week of July, it may appear that the health of the business is in sudden decline when in fact finances are steady.
As opposed to cash accounting, accrual accounting presents a more unified picture of your business. By recording expenses and income when they are incurred, as opposed to paid, you are able to the appearance of dramatic financial shifts from month to month.
For instance, if one of the payments you need to make in July is for an annual subscription to a software, cash accounting would show the entire payment hitting in July, while accrual accounting would break the payment into twelve installments and spread them over the year. This presents a more accurate representation of that purchase’s use within the business and would not likely cause concern among board members or investors who might otherwise wonder what happened in July.
While accrual accounting presents a better long-term picture of your business’s health, it makes understanding short-term cash flow more complex. The subscription payment may be broken across twelve months in your books, but the company providing it expects payment all at once. It’s up to you to make sure that you have enough cash on hand to cover that expense when it comes time to pay.
Maintenance of your company’s books also becomes more complex with accrual basis accounting. The rules and principles surrounding accrual basis accounting may require the expertise of a CPA or automated solution to make sense of. Tax time also often raises questions, as it’s common for business owners to question tax payments made on income that has not yet been received.
It is important for business owners to understand the main tenets of accrual accounting in order to confidently speak to their books in board meetings or with investors and to make smart spending decisions with cash flow in mind.
Determining the Best Fit for Your Business
Cash basis accounting fits a small subset of business owners’ needs. If you own a very small business without accounts receivable, like a sole proprietor service business, this may be the best solution for you.
However, the vast majority of businesses will need to adopt accrual basis accounting, especially when presenting their finances to anyone else involved in the business. Switching between the two is best done at the start of the calendar or fiscal year and under the guidance of accounting professionals. Accrual accounting takes some getting used to, but it is likely the best fit for your business in the long run.