Congratulations! You have a business idea and are in the process of getting the business up and running. While your to-do list might be a bit intimidating, don’t forget a small but vital decision to make when it comes to your back office: will you use the accrual or cash accounting method? It’s crucial to know the differences between accrual vs cash accounting, how this decision can impact your business, and which method is the best option for your business goals, processes, and industry. Below you will find the key differences between accrual vs cash accounting methods, and why you need to choose one method for your business.
Why do I need to choose an accounting method?
Your business books are the foundation of your business’s finances. You must have procedures, methods, and internal controls in order to maintain your books in an organized manner and stay in compliance with applicable laws and regulations. Choosing your accounting method is one of the first steps in establishing your back office. Doing so will provide protocols for when your business recognizes revenues and expenses. The main difference between cash accounting and accrual accounting method comes down to timing: will you recognize revenue and expenses when the transaction hits your bank account, or when they’re incurred?
Accrual accounting method
In accrual accounting, revenue and expenses are recognized when they are earned. When a product or service is delivered to a client, the business will recognize the revenue as it has been earned, even though the payment has not yet been received from the client. Expenses in accrual accounting are also recorded when they are received—before the actual cash is paid out.
The accrual accounting method is most common in mid-size to larger businesses as it is acceptable under GAAP and is typically required for filing audited financial statements. Because the accrual method accounts for receivables and payables, it can provide a more accurate picture of the business’s overall financial health, which can be valuable to the business itself and potential investors and banks.
There are a few downsides to the accrual accounting method. One is that it makes managing cash flow trickier, as the cash isn’t actually in the business bank account when the revenue is recognized on the books. Accounting is a little more complex due to the need to account for unearned revenue and unpaid expenses. It can also become an issue if client accounts fail to pay for extended periods of time and the business isn’t keeping up with collections.
Cash accounting method
The cash accounting method differs from accrual accounting as the revenue and expenses are recognized only when the cash is either received or paid out. The cash accounting method is ideal for small businesses as it is a much simpler process and makes tracking cash flow easier for small business owners. This method can also be beneficial for small businesses as you are only paying taxes on the money earned (not expected).
The downside of cash accounting is that it may overstate the amount of cash the company has due to the fact that account payables aren’t recorded as incurred. You need to be careful not to exceed the cash on hand when planning expenditures. This might make it difficult for an investor to conclude if a company is indeed cash-flow healthy or not. It is also important to note that the cash accounting method is not acceptable under GAAP, and not permitted for certain businesses by the IRS.
Accrual vs Cash accounting method examples
Revenue
A business sells and delivers $10,000 of goods to a client on March 15 with net 30 payment terms. The client pays the invoice on April 5.
Cash accounting method:
The business would record the income on April 5, for a total revenue of $10,000 in the month of April.
Accrual accounting method:
The business would record the income on March 15, for a total revenue of $10,000 in the month of March.
Expenses
A business ordered $5,000 worth of office supplies from a vendor on March 15 with net 30 payment terms. The business pays the invoice on April 5.
Cash accounting method:
The business would record the expense on April 5 for a total expense of $5,000 in the month of April.
Accrual accounting method:
The business would record the expense on March 15 for a total expense of $5,000 in the month of March.
Above you can see how accrual vs cash accounting methods can alter the company’s financial statements month-to-month. Although the revenue and expenses were purchased and paid for on the same days, the different accounting methods will recognize them in different months.
How to manage your accounting
If you’re a new business owner, managing your books with either cash or accrual accounting methods can sound daunting. The good news is that cloud-accounting apps can do most of the heavy lifting for you. Apps such as Xero, and additional integrated cloud-accounting apps, can automate processes based on your chosen accounting method. Automations with cloud accounting apps reduce human error and simplify tedious processes. Xero can take the guessing game out of the timing of revenues and expenses and can generate reports based on your accounting method.
Our team can work with you to determine which cloud-based accounting apps could benefit your business, and ease your biggest pain points. Integration is simple and can save you countless hours.
It can be a bit confusing for a new business owner to determine just which accounting method is right for the business. You’ll need to consider many different factors, including goals, size of the business, industry, protocols, and revenue expectations. If you’re not sure which one is right for your business, send us a message. Our team of experienced business CPAs and CFOs can help you determine which accounting method makes the most sense for your business.