Your products and services may drive revenue through your company. But at the end of the day, it’s accounting that keeps you in business. Well-structured and timely accounting helps every member of your team know where each dollar is going and plan accordingly. Disorganized or inconsistent accounting, on the other hand, can impact your ability to make data-driven decisions, and put your business in jeopardy. That’s why it’s essential to know the difference between the two most commonly used accounting methods — and which one is right for your business.
What is the difference between cash and accrual accounting?
While there are several significant differences between accrual and cash accounting, the biggest one essentially boils down to timing. Specifically, when your revenue and expenses are recognized and recorded.
Let’s take a closer look at each type of accounting, and how it’s used to record your financial transactions:
How does cash basis accounting work?
Cash basis accounting records your revenue the moment the payment is received. It also records your expenses as soon as they’re actually paid. Businesses that use the cash basis method of accounting don’t record any incoming or outgoing cash until the change is reflected in their bank account.
Here’s an example of how cash basis accounting works for a typical small business:
Say your business bills a customer in January for a $1,000 order they placed that month. Your bill terms are net 30, meaning they have a full 30 days to pay for their order. You’ve sent the shipment, they’ve received your products, and now you’re just waiting for payment. Finally, in February, your customer pays their invoice. That’s when you record the revenue. Not in January, when the order was placed, but in February, when the payment hits your account.
Because cash basis accounting is a reactive form of accounting, it’s the simpler method of the two. That makes this accounting method ideal for small businesses and sole proprietors who operate with a lean team.
How does accrual accounting work?
Accrual accounting is a more complex accounting method that records revenue when it’s earned and expenses when they’re incurred, regardless of when the credit or debit is reflected in your account. This accounting method is based on the matching principle, which aims to match revenue to expenses within the same accounting period, using a series of transaction logs called journal entries.
Here’s how accrual accounting would work for the same business used in our earlier example:
Your business bills a customer in January for a $1,000 order they placed that month. Your bill terms are net 30, so while they received the bill in January, it won’t be due until February. However, because you use accrual accounting, you record that $1,000 of revenue in your income statement for January. You also mark that $1,000 in your January “accounts receivable” report as money currently owed to you. Once your customer pays their bill, instead of recording that payment as revenue, it’s simply deducted from your accounts receivable to balance out your books.
As you can see from this example, accrual accounting is more complicated than cash basis accounting because of the extra steps involved in recognizing revenue and expenses when they occur. But this real-time financial tracking method provides the most accurate picture of your company’s current health, since it includes every dollar currently owed to your company and by your company at any given moment.
Cash basis vs. accrual basis accounting: Which is better?
Each accounting method has its advantages and drawbacks. Cash basis accounting is simple, easy to manage, and quick to pick up. But it can also give an inaccurate picture of your business’s overall financial health. Especially if there are often significant delays between when you take orders and receive payment, or incur expenses and pay back those expenses.
For that reason, cash basis accounting is not the ideal option for:
High revenue businesses.
If you handle thousands of transactions, cash basis accounting can oversimplify your records, obscuring your actual cash on hand and incoming revenue.
Businesses offering credit.
Companies that invoice customers for products or services after the order is placed may not benefit from cash basis accounting, because it doesn’t recognize revenue until payment is received. For example, if your business frequently offers net 30 invoicing terms, your true revenue and financial performance can be delayed by up to a month every time a customer places an order.
Companies seeking funding.
Venture capital firms and investment partners may prefer to see financial statements built on accrual accounting, because these statements offer a more accurate view of your financial position.
In these cases, or if your company is preparing for significant growth, accrual accounting can be the smartest option for your business’s accounting standards. While accrual accounting may require a bit more expertise and reporting, its clear statements, transparent revenue and expenses tracking, and scalability can make it the best option for expanding businesses.
Want more? Escalon has helped over 5,000 small businesses across a range of industries to optimize routine business functions, like taxes, accounting, insurance, payroll and HR. Talk to an expert today.
This material has been prepared for informational purposes only. Escalon and its affiliates are not providing tax, legal or accounting advice in this article. If you would like to engage with Escalon, please contact us here.