Cash Basis vs. Accrual Accounting Explained

There are multiple ways to track the revenue of your business. You can track money as it comes in—and goes out—through cash-based accounting, or you can project the financials of your business through time using the accrual method. 

Each of these accounting methods has its pros and cons, particularly for small business owners. Learn more about cash vs. accrual accounting to determine which makes the most sense for your business.

What is cash-basis accounting?

Cash basis accounting records transactions when the money comes in and when money goes out. For example, a restaurant will record the costs of receiving provisions to cook with and will record the income from customers every night. Cash-based accounting is immediate and focuses only on money exchanging hands. 

What is accrual-based accounting?

Accrual accounting, on the other hand, records revenue when it is earned, not necessarily when your company is paid. Similarly, it records expenses when they occur, not necessarily when they are actually paid. 

For example, if a customer buys a product or service, the business owner would record the income immediately even if the customer has 30 days to pay an invoice. It doesn’t matter that the customer hasn’t paid the invoice yet—the business records the income from the sale. 

The accrual basis of accounting also applies to expenses. If you pay $120 per year for marketing software each January, you can record a $10/month expense accrued over the course of the year. This makes your books look more even than if you had one $120 charge in 1 month without any repeating charges during the rest of the year. 

The accounting method you choose will depend on your business model and how you track your finances. 

Should small businesses use cash or accrual accounting?

There is no golden rule for whether small businesses should use cash or accrual accounting. Some small businesses start out immediately accruing their expenses, while others continue to use cash even as they grow. 

There is one caveat—the IRS requires business owners to use the accrual method if their business is a corporation that averages more than $25 million per year in gross receipts. 

A potential indicator of the type of accounting you should use is the turnaround time within your business. For example, a home contractor might work on four or five major projects each year. They would likely have agreements with clients to pay part of the funds up front and the remaining balance when the work gets done. In this case, the accrual method might be better in order to help track accounts receivable and future revenue against current expenses.

If you operate a small business with a short transaction window or offer a monthly service (like a SaaS company or keep your clients on retainer), a cash-based system might be easier to manage. 

Additionally, your expenses can dictate whether a cash vs. accrual accounting basis is right for you. If your expenses remain stable each month, then you might feel more comfortable using cash than if your costs come in waves.  

When in doubt, speak with an accountant. They can review your current accounting model and make recommendations for you moving forward. 

What are the pros and cons of accrual-based accounting?

The biggest benefit of cash-based accounting is that it is easy. You can clearly record when you have money and when you don’t. You can also track your cash flow easier because you know how much you have on hand. However, there are some significant benefits to accrual-based systems. 

• You can track expenses when they occur, even if your accounts payable team takes time to process invoices. 
• You will have a better idea of incoming funds from your accounts receivable department. 
• You can better forecast your expenses and set clear budgets based on what you know you owe. 
• You can expand your business past the $25-million limit without having to adjust your accounting method.

Some business owners prefer to use accrual-based accounting if they accept multiple payment types and have several clients. This means laggard clients who refuse to pay won’t hold up the cash flow. 

However, there are some drawbacks to accrual-based accounting. This process is harder to keep track of and requires an understanding of basic accounting principles. Plus, if you already use a cash-based system, you will need to retool how you record cash flow. You may need to redo your books from past years so your expenses line up correctly. If you have been in business for several years, this conversion process can take a while.

_{Information provided on this blog is for educational purposes only, and is not intended to be business, legal, tax, or accounting advice. The views and opinions expressed in this blog are those of the authors and do not necessarily reflect the official policy or position of Lendio. While Lendio strives to keep its content up-to-date, it is only accurate as of the date posted. Offers or trends may expire, or may no longer be relevant.}