Cash vs. Accrual Accounting: which method is best for your business?

The full financial picture of any company is like trying to solve a scrambled Rubik’s cube: it’s complicated. This makes proper accounting essential to both the financial health of your business and its overall potential for longevity.

There are two standard methods of business finance tracking: the cash method and the accrual method. Understanding the difference between these two methods will help you in determining which method is the best fit for your business.

What is cash accounting?

The cash accounting method tracks income when it is received and expenses when they are paid and is the most popular method for small businesses and personal finances. If you’ve ever balanced a personal checkbook or entered what you’ve spent and earned into a spreadsheet, then you have a good idea of how cash accounting works.

For example: you own a business that builds websites for companies and finish a website in August, but your company doesn’t get paid until October, then that income is recorded in October’s books. If the client never pays, then the income is never recorded.

The benefits of cash accounting

The cash accounting method accounts for real-time transactions, meaning that transactions are recorded when cash changes hands. For small businesses who are worried about overspending and want to know exactly how much cash they have on hand, the cash accounting method may be a good fit for your business.

There are also tax benefits to cash accounting. Finance and accounting professionals can work with your tax personnel to determine the most advantageous method for your situation. Since some companies are restricted from using< the cash accounting method, it’s important to consult with an accounting professional who can help to identify whether cash accounting is a viable option for your business.

The disadvantage

While cash accounting is essentially a “simpler” way of maintaining a business outlook, it can also produce an erroneous picture of your company’s performance since revenue isn’t recognized until the money is in the bank.

What is accrual accounting?

Accrual accounting takes a more hypothetical approach to your big-picture business finances; accountants or financial firms count income when it is billed and expenses when they arrive.

Unlike the cash method, the accrual method records the client invoice the day it is received, even if it isn’t paid until a month later. In the accrual method, accounting professionals will use a balance sheet to record the offsetting asset or liability so you can maintain a good sense of your business’ current financial status.

The benefits of accrual accounting

Since accrual accounting records transactions upon completion of a delivery or service, it allows a company to see how well it’s doing and have the ability to make better predictive decisions regarding the future.

Because you know how much is anticipated in the short-term (regardless of it being in your account yet), accrual accounting gives you a better sense of your cash flow needs as well as any outstanding expense liabilities that are due. Financial professionals will usually add another reporting function that lists actual cash available at any given time.  

The disadvantage

Since the accrual method records all transactions, regardless of the payment being received, your books could could reflect revenue even if your bank account is completely empty.

Which one is right for your business?

There are a few factors to consider when deciding whether to use cash or accrual accounting methods. Here are a few things to keep in mind:

Size and Industry

The size and industry of the company you run are major determining factors. For instance, C corporations who generate over $10 million and S corporations who generate over $20 million in average gross revenue over the past 3 tax years, are excluded from using the cash accounting method.

Inventory

The size and industry of the company you run are major determining factors. For instance, C corporations who generate over $10 million and S corporations who generate over $20 million in average gross revenue over the past 3 tax years, are excluded from using the cash accounting method.

Ease of Reporting

The accrual accounting method is more difficult to report from a tax perspective, though financial service experts can easily handle this aspect.

Insight into your business

Cash accounting doesn’t give much insight into the overall health of your business as far as sales, expected income, or expected expenses go.

Your bottom line is too important to track haphazardly, either by using the wrong method or not using one at all. Learn more about how to track your company’s income and expenses.

Financial experts can also give you more insight into which type of accounting method makes the most sense for your business and set it up for you so that you can keep focusing on the most important thing: running your company. Hiring a reputable financial firm can help your company reduce the risk of spending too much or straining vendor/contractor relations with late payments. Get expert advice now.