Cash and accrual accounting methods each have advantages and disadvantages, but once you pick a particular accounting method, it is important to apply it consistently. So how do you know which accounting method is best for your business? If you’re going to be tied to the method of accounting you choose, you want to make the optimal choice. This guide offers an overview of each accounting method and advice to help you choose the best one for your small business.
[Related read: Difference Between Accounts Payable and Accounts Receivable]
What is cash accounting?
Cash accounting is the simplest and most basic method of accounting and focuses on cash inflows and outflows. It is predominantly used by individuals for personal accounting, as well as by small businesses.
In a cash-based accounting system, revenues and expenditures are recognized only when money is exchanged, irrespective of when goods or services are delivered. This means this method does not introduce the additional complexities of accounts payables, receivables, or current assets and liabilities. [Check out these nine accounting tasks you should do every day.]
This also means that any sales or expenses aren’t reflected in the financial statements until the amount is realized, and investments in inventory are shown as expenses until they can be sold for cash. With cash accounting, it’s more difficult to accurately assess your business’s financial performance.
Advantages of cash accounting
For small businesses, cash-based accounting offers plenty of advantages.
- Ease of use: Cash accounting is largely driven by its simplicity, well suited for small businesses and sole proprietors who can take care of accounting with just a pen and notebook.
- Better cash flow projections: Since the entire accounting and financial reporting system revolves around cash flow, cash accounting can provide a better picture of that. More complex accrual-based systems often lose that clarity.
- Tax advantages: If you only record business income and expenses when cash changes hands, you may take advantage of significant tax breaks by timing your transactions. Speed up expenses or slow your revenues to legally lower your tax liabilities for a period of time.
Disadvantages of cash accounting
Cash-based accounting comes with some clear disadvantages, making it unsuitable for certain types of businesses.
- Misleading and inaccurate reporting: A business owner can show a profit by not paying bills during a period of time, even though they have incurred those expenses. This makes the system easy to abuse, and better for personal tracking rather than an assessment from an investor or bank.
- Inventory management: In cash-based accounting, inventory is treated as an expense. It doesn’t become an asset until it is sold for cash. This can skew your figures, especially for businesses who have their capital tied up in inventory, or who hold inventory for long periods of time. The IRS restricts businesses that maintain inventories from using the cash method of accounting, with certain exceptions.
Key Takeaway
While cash accounting methods are easy to use, allow for better cash flow projections, and offer tax advantages, they can lead to inaccurate bookkeeping and skewed inventory figures.
Editor’s note: Looking for the right accounting software for your business? Fill out the below questionnaire to have our vendor partners contact you about your needs.
What is accrual accounting?
Used in most professional organizations and businesses around the world, accrual accounting recognizes income only when goods and services are delivered, and expenses are recorded when they are incurred. [Read related article: Choosing the Right Small Business Accounting Software]
For example, if you were hired to construct a house, you would record revenues from the project as it was completed, irrespective of when the customer paid the money. The same applies for expenses, which are reported when they are incurred, not when you pay them.
Accrual accounting matches revenues and expenses to the same time period, allowing for a more accurate assessment of a company’s profitability and financial performance. It also uses double-entry accounting with accounts for receivables, payables, and inventories.
While accrual accounting is indispensable in modern businesses, it does have its shortcomings, such as a steep learning curve and greater complexity that can be a burden for small business owners. If you use accrual accounting, accounting software solutions and professional accountants are a necessity.
Another key drawback is the disregard for cash and payments, which can create cash flow issues. That’s especially true when coupled with tax liabilities, which are based on sales and income before the payment is made.
[Related: Difference Between Net and Gross Income]
Advantages of accrual accounting
The accrual system has undeniable advantages for businesses of all sizes.
- Accurate financial reporting: The accrual system accurately depicts a company’s profitability and financial performance during a period of time, perfectly correlating the sales and expenses arising from them during that same period.
- Improved planning and reporting: This system allows for analysis, planning, and strategic decision-making in organizations, with financial reports that match operating activities.
- GAAP compliance: Generally Accepted Accounting Principles (GAAP) mandate the accrual system of accounting. The accrual method’s compliance with these accounting standards is crucial if you’re looking to raise or borrow funds from investors and banks.
Did You Know?
Accrual accounting allows managers and business decision-makers to see a clear picture that is often missing from cash-based accounting.
Disadvantages of accrual accounting
Despite the undeniable benefits and widespread adoption in business, the accrual system has certain drawbacks.
- Steep learning curve: Unlike the straightforward cash method, accrual-based accounting requires time and effort to learn, understand, and put into practice. Small business owners may lack the skill or resources to do this.
- Cash flow uncertainties: By indicating profits before they are realized, this system can create uncertainties with planning, budgeting and strategizing. It can also incur tax liabilities before the money ever reaches your account.
Should small businesses use cash or accrual accounting?
With this side-by-side comparison, you can see the option that best suits your requirements.
| Cash accounting | Accrual accounting |
|---|---|
| Revenue recognized when cash is received | Revenue recognized when earned on delivery of goods and services |
| Expenses recognized when paid with cash outflow | Expenses recognized when incurred, irrespective of actual payment |
| Keeps track of cash inflows and outflows to report financial performance | Keeps track of receivables, payables, inventories and depreciation to report performance |
| Tax liabilities only on money received | Tax liabilities may arise even before money reaches the account |
| Simple, easy to use, and requires no additional tools or professional help | Involves a learning curve, requires accounting tools and professional assistance depending on the complexity |
| Not accepted by banks and investors | GAAP compliant and universally accepted by banks and investors |
| Best suited for freelancers, sole proprietors, and independent consultants or contractors | Required for businesses of all sizes with inventories, staff and assets |
How to record your transactions
Accounting, financial management and reporting may seem overwhelming at first; however, there is a vast array of accounting solutions with easy-to-use, intuitive interfaces. You’re free to hire an accountant, but software also allows you to maintain your books professionally without outside assistance.
With high-quality accounting software that offers different features, capabilities, and pricing to suit businesses of all sizes, running a company has never been easier. You can even do accounting from an app on your mobile phone with most leading solutions. Learn more about individual accounting software solutions available on the market in our QuickBooks Online review or our FreshBooks accounting software review.
