Cash basis accounting and accrual basis accounting differ in the way they track revenue and expenses, as well as which types of businesses they tend to work best for. Small businesses might prefer cash basis accounting because it’s easy to implement and maintain. But bigger or more complicated businesses need the more holistic financial picture you can get from accrual basis accounting.
With both cash and accrual basis accounting, accounting software like QuickBooks Online can automate workflows and minimize errors. But if you’re managing accounting manually, it can be tough to know how to use these methods to manage your finances, so let’s get into it.
What is cash basis accounting?
Cash basis accounting records income and expenses when you actually receive or issue payments. You don’t track or record revenue you haven’t received yet or costs you haven’t paid out on yet.
How does cash basis accounting work?
With cash basis accounting, if your business performed a service but is still waiting on payment, then that revenue is not represented in your records yet. If you issue an invoice in July with a due date in August, then you won’t record the revenue from that invoice until you receive the actual payment in August.
Similarly, if you’ve incurred an expense but haven’t paid it yet, cash basis accounting dictates that you don’t record the expense until you’ve actually issued your payment and the money has left your account.
Why would a business use cash basis accounting?
Some businesses use cash basis accounting because it’s relatively easy to implement. Because you don’t have to track a lot of in-progress expenses or revenue streams, cash accounting is a simple way to track your finances and cash flow.
But keep in mind that cash basis accounting is going to be less accurate than some other accounting types, including accrual basis accounting.
What is accrual basis accounting?
Accrual basis accounting tracks revenue and expenses as soon as they’ve been incurred. This is a more holistic view of your businesses’ finances than you’d get with cash basis accounting.
How does accrual basis accounting work?
With accrual basis accounting, you’ll record revenue from sales and payments for expenses at the time they occur, regardless of whether or not money has yet changed hands. If you bought a bunch of inventory tomorrow, then you would record that expense as soon as the order was put in, even if you haven’t paid the invoice yet.
Similarly, if you perform a service you’re owed money for, you’d record the revenue from that service as soon as it’s completed — rather than waiting until you’re paid.
Why would a business use accrual basis accounting?
Because accrual basis accounting takes all expenses and all revenue into account as soon as each incident happens, it gives a more accurate picture of your business’s financial health than cash-based accounting systems. Accrual basis will tell you not only how much money you have currently accounted for but also what your finances are going to look like after pending payments and costs settle up.
But while accuracy is a good reason to go with accrual basis accounting, it’s also more complicated to implement than a cash-based accounting system. Accrual basis accounting has to adhere to GAAP (Generally Accepted Accounting Principles), and it can be complicated to track.
What is the difference between cash and accrual accounting?
The main differences between cash basis and accrual basis accounting include:
- Timing of expense tracking.
- Matching principle adherence.
- Difficulty of implementation.
- GAAP adherence.
While accrual basis accounting tracks expenses as soon as they occur, cash basis accounting delays recording them until money has actually changed hands. That makes accrual basis accounting more complicated to maintain since you have to track accounts payable and accounts receivable to make sure your records match your payment activity.
While cash basis accounting is easier to implement and maintain, accrual basis accounting gives you a more accurate picture of your overall business finances. Because accrual accounting includes both payments and costs you’ve incurred now as well as in the future, you can get a better idea of cash flow.
Cash basis also doesn’t follow the matching principle, which is the concept of matching revenues with their related expenses during the period they were incurred. Matching expenses with the time of occurrence lets you calculate net income for a given time period.
Cash vs. accrual accounting examples
Let’s take a look at how cash basis compares to accrual basis accounting with a simple example:
If your company provides services in December, invoices the client in January, receives payment in February, then the timing between when a service was provided versus when you actually got paid for it spans the course of three months.
If you use cash basis accounting in this scenario, then you would not record the revenue from your services until February, when the payment is actually received and enters your account.
If you use accrual basis accounting in this example, then you would record the revenue from the service in December, when the service was performed. That gives you a more accurate financial picture of where your company is financially because you know that you’re owed a certain amount of income, even though you won’t actually receive the money for a couple more months.
Which to choose: Cash basis accounting or accrual basis accounting
Which accounting system you choose comes down to how big your business is and how precise you want your financial records to be.
We recommend cash basis accounting for:
- Small businesses or freelancers.
- Businesses with minimal receivables and payables.
- Companies with no inventory.
- Side hustlers.
We recommend accrual basis accounting for:
- Large businesses or corporations with complex accounts receivable.
- Companies that carry inventory.
- Businesses with high upfront costs or substantial prepayments.
- Companies in highly regulated industries.
- Businesses that require audits or external reporting.
Of course, the best method for your business is up to you, and you may just have to give both a try to see which one suits your operations best.
However, you can also ease your accounting burden by getting free accounting software for easier management, regardless of which method you go with.
