Cash Basis Accounting vs Accrual Accounting

What is the definition of cash basis accounting?

The cash basis of accounting records revenues when cash is received and expenses when it is paid. This method does not distinguish between accounts receivable and payable.

Many small businesses choose the cash basis of accounting because it is easy to maintain. It is simple to determine whether a transaction has occurred (money is in or out of the bank), and there is no need to track receivables or payables.

The cash method is also useful for tracking how much cash the business has at any given time; simply look at your bank account balance.

Furthermore, because transactions are not recorded until cash is received or paid, the business’s income is not taxed until it is deposited in a bank account.

To summarize, here is a brief overview of the benefits and drawbacks of cash basis accounting:

Advantages of cash basis accounting:

The simplest method of accounting

Quickly reveals how much cash you have on hand at any given time.

Transactions are not recorded until the money is in or out of the account, giving you more control over your expenses and income for tax purposes.

Cons of cash-based accounting:

Does not show you your company’s liabilities or the liabilities that customers owe you. As a result, you may believe your company is financially stronger (or weaker if you have several outstanding invoices) than it is.

The IRS allows only certain types of businesses to use cash-basis accounting. You cannot use this method if you provide credit to customers; if your gross receipts exceed the IRS requirement of $30,000,000 on average over the previous three tax years; or if you must maintain inventory on hand to record revenue.

It can be difficult to transition to accrual accounting if you decide to do so or if your business grows.

What is accrual-based accounting?

In accrual accounting, revenues and expenses are recorded when they are earned rather than when they are received or paid.

For example, if you finished a project for a client in February but were not paid until April, revenue from that project would still be recorded in February, even if the cash did not arrive until 60 days later. Because it provides a more complete picture of your company’s finances, it is more widely used than the cash method.

Furthermore, because many businesses eventually need to switch to the accrual method as they grow or want to attract investors, it can make a lot of sense to start with accrual right away.
It’s important to note, however, that accrual basis accounting does not provide an accurate picture of your cash flow. If you use accrual accounting, you must keep a close eye on cash flow to avoid potentially disastrous outcomes.

It’s worth noting that some businesses do their bookkeeping on a cash basis but file taxes on an accrual basis. When it comes time to prepare for taxes, they take the necessary steps to convert from cash basis to accrual basis accounting.

Here’s a quick overview of the benefits and drawbacks of accrual accounting:

Pros:

Provides a more accurate and transparent picture of your business’s finances.
enables you to make better long-term decisions.

It saves you from having to convert to cash basis accounting as your company expands or when tax time rolls around.

Cons:

More complicated than cash basis accounting, and may necessitate the assistance of a professional bookkeeping service or accountant.

Increases the risk of internal fraud compared to cash-basis accounting, necessitating a system of controls.

What does it mean to “record transactions”? The cash and accrual methods require recording transactions at different times. However, what does recording a transaction mean?

Every business must record, or write down, all of its financial transactions in a ledger, which is known as bookkeeping. This used to be done manually on paper, but now most business owners use bookkeeping software.

You must do this if you intend to claim expenses at the end of the year. You’ll need one place to keep track of all your income and expenses (you’ll need this information to file your taxes).

Consider an example of how cash and accrual accounting affect the bottom line in different ways. We will examine a month’s worth of transactions for a hypothetical web design company.
Suppose you conduct the following transactions in a month of business:

• Send a $5,000 invoice for a web design project completed this month.
• Received a $1,000 developer fee statement for work I finished this month.
• Pay $75 in fees for a bill received last month.
• A client paid me $1,000 for a project that was billed last month.
• Using the cash basis method, this month’s profit would be $925 ($1,000 income minus $75 fees).
• Using the accrual method, this month’s profit would be $4,000 ($5,000 in income less $1,000 in developer fees).

As you can see, the two methods produce very different results. These distinctions also apply when it comes to taxes—consider how this web company’s taxes would differ if they used the cash method or the accrual method.

How cash vs accrual accounting impacts your taxes:

One of the most significant distinctions between cash and accrual accounting is that each method influences the tax year in which your income and expenses are recorded.

When income is received, it is recorded according to cash-based accounting. Income is tracked using the accrual approach as it is received.

Consider that the aforementioned transactions happened in November and December of 2023 to understand the impact on taxes.

If you use the cash basis, you will not record the transaction until you receive the payment, at which point it will be included in your 2024 taxable income.

Cash basis and accrual accounting in software:

Many accounting software platforms allow users to choose between cash or accrual-based accounting.

In Quickbooks, you can choose between cash and accrual as your accounting method. You can also run reports using either method to see how your finances look in each.

Wave also provides both cash and accrual reporting options, though accrual is the default. You can switch to cash by selecting the option from the Report Type menu.

Velan offers both choices, with cash basis being the default. Velan uses both software and human bookkeepers.

Should a small business follow cash or accrual accounting?

If your company has averaged more than $25 million in gross receipts over the last three years, the IRS requires you to use the accrual method.

If your business does not meet those requirements, you are welcome to use the cash method.

Having said that, the cash method is usually more effective for smaller businesses that do not carry inventory. If you have a lot of inventory, your accountant will most likely recommend using the accrual method.