Cash and Accrual Accounting: What’s the Difference?
Cash and accrual accounting are methods for organizing your business' books, but they can have a major impact on your business finances.
In this article, we explore the difference between cash and accrual accounting and the pros and cons of each.
When you set up your accounting books, whether they are physical, virtual, or part of an accounting software like QuickBooks or Wave, you will have to choose between cash and accrual accounting. Cash and accrual accounting are both methods for organizing your business’ books or accounting records. Once you choose an accounting method, it is difficult to switch (most businesses making a change will have to apply to the IRS for permission), so it’s important to make the best decision for your business from the beginning.
Cash and Accrual Accounting: What the Difference?
The main difference between cash and accrual accounting is the date that an expense or income is recorded in your book of accounts (whether that is a physical or virtual book). With cash accounting, an expense or income is recorded when you actually pay the expense (money moves out of your account) or you are paid (money comes into your account). With accrual accounting, an expense or income is recorded when you incur the cost (when you purchase a service or products, regardless of when you actually pay) or earn the income (when you send an invoice, regardless of when it is actually paid).
Cash and Accrual Accounting Example
Let’s look at an example. Emma’s Events is a popular event and catering business. Today, Emma had two transactions:
- Emma ordered two cases of eggs from a local farm. She had to pay her egg bill within 7 days.
- Emma catered a party for her best customer. She sent her best customer an invoice, and they have 30 days to pay Emma.
With cash accounting, Emma will not record the payment of the egg bill until she actually pays the local farm and the cash leaves her account. Similarly, she won’t record the income from the party for her best customer until the customer actually pays Emma and the cash enters her account.
With accrual accounting, Emma will record both the expense that she has to pay to the local farm for eggs and the income from the party for her best customer on today’s date, since they were both incurred today.
While these differences may seem minor, they can have a major impact on how you manage your finances, your taxes, and what information you can learn from your financial documents. Let’s get into the details.
What is Cash Accounting?
Also called cash basis accounting, in cash accounting an expense or income is recorded when the cash actually moves in or out of your account.
- Much simpler to set up and maintain.
- Easier to track cash flow, which makes it easier to manage cash and avoid a cash crunch.
- Typically does not require specialized training.
- Makes it more difficult to evaluate the health of your business.
- Not acceptable under GAAP, which regulates accounting methods for publicly traded companies.
Best For Businesses That…
- Are sole-proprietors or very small businesses.
- Do not offer (a lot of) credit to their customers and/or do not use (a lot of) credit on their purchases. This does not include the use of credit cards.
What is Accrual Accounting?
In accrual accounting an expense or income is recorded when the expense or income is incurred, regardless of when they are earned.
- Gives business owners a better idea of the health of the their business through detailed records like accounts receivable and accounts payable.
- Easier to evaluate the long term financial health of a company.
- More difficult to track cash flow, which makes it more difficult to manage cash and prevent a cash crunch.
- More complicated and can be difficult to set up. May require additional training or specialized professionals like an accountant or bookkeeper.
Best For Businesses That…
- Offer credit to the their customers and use credit for their own purchases.
- Have smooth cash flow.
- Are large and/or publicly traded companies.
- Are required by the IRS to use accrual basis accounting.
Whether you choose cash or accrual accounting, it is important to pay close attention to your business finances so you can make the best business decisions. Check out this short course on Business Finances 101 to learn more.
This article is meant for educational purposes and provides general information on this topic only. For advice about your specific situation, please consult with your tax and/or accounting professional.
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