Cash accounting vs. accrual accounting

When managing your business’ money, you will use one of two accounting methods-cash or accrual. The difference between the two is all about the timing of when your company accounts for expenses and revenue. Let’s take a look:

Cash method

The cash method of accounting is all about, well, cash. Reports are based on the dates that cash is paid out or received.

For example, if you pay March rent on March 1st, and you pay April’s rent on March 31st, your reports will indicate excessive rent expenses in March, and no rent expense in April, based on the dates of the checks. If you only look at your business’s financial reports annually (say it ain’t so!), then these monthly ups and downs may not matter.

The cash method is simple. It is also familiar, since most individuals and families look at their own finances in this light. For freelancers and sole proprietorships, the cash method is generally adequate, and tax returns for these entities are usually filed on a cash basis. So the pros are its simplicity and familiarity.

The con side is the aforementioned ups and downs. Expenses such as rent are constant, and any one month’s reports are most accurate when all such costs are accounted for. Ups and downs in a business are more commonly due to volume or seasonality, and varying routine costs can cloud the picture your financial reports are trying to show you.

Accrual method

Accrual accounting is based on when expenses are incurred and when income is earned, regardless of when checks are written or deposits made. It’s a bit more complex than cash basis accounting, but provides a much better view of what’s going on in your company. This method applies the matching principle, which matches revenue with expenses in the correct time period.

Let’s say you pay a year’s worth of general liability insurance. Recording that on an accrual basis means that you show only 1/12th as an expense that month, and the remainder is shown on the balance sheet as Prepaid Expense. At the end of each of the following 11 months, a closing entry is made to show another 1/12th of expense. At the end of 12 months, you’ve shown all 12 months’ worth of insurance expense, and the Prepaid Expense has been reduced to $0.

This is the most common accounting method used by businesses. One of the main benefits is that you can get a more immediate, realistic understanding of income and expenses over a longer period of time. Put more simply, you don’t earn all your revenue in one month, so why record all of your insurance expense in one month?

While accrual accounting does not tie exactly to how much money is in the bank, you can reconcile back to that number. And in so doing, you see what outstanding checks and deposits have yet to clear the bank - a very good thing to know and keep in mind.

So what’s best for you?

Cash basis is great for startups because of its ease, and management can focus on planning and doing. However, it’s best to ask some basic questions before deciding:

  • Will the books be audited?
  • Do you need to obtain bank financing?
  • Will the company go public?

If ‘Yes’ is the answer to any of these, accrual basis would be the best way to go. External parties need more information that just how much money is in the bank.

Not sure which accounting method works best for you? Just want to rest assured that your bookkeeping is done accurately? Give us a call so we can have a conversation about your business’ needs.

Leave a Reply

Your email address will not be published. Required fields are marked *