Cash-based accounting and accrual accounting are two sides of the same coin. There are some major differences, but they are similar in concept because the end goal is to do the back-office accounting of a business.
Suppose you handle your accounting work in-house or want to get outsourced accounting services. In that case, you must become more aware of accounting basics to communicate better with your accounting team.
Canada Hustle
Cash basis provides an immediate reflection of the revenue in hand and expenses, and the accrual method predicts revenue and expenses based on transaction history. They are both methods for financial reporting but no matter which one you choose, you need to keep using the same process consistently.
More importantly, you need to be aware of both processes to understand which will work best for your business. Here I am sharing some basic concepts to help you understand the difference and make a smart decision.
Cash Accounting vs. Accrual Accounting
Accrual accounting paints a clearer picture and is the more popular choice for many companies, but a cash basis also has its good sides. Cash-based accounting only records income and expenses as and when the bills are made and paid.
However, accrual accounting records income and expenses based on bills and earnings. If your company’s annual revenue is below $25 million, there are no set GAAP or accounting rules that the FASB will hold you accountable to. You can use any method that suits you.
The Canada Hustle team talked to Andrew Cussens, the Owner of FilmFolk, about choosing accrual accounting over cash accounting. Here is what he said:
“Accrual accounting gives us a much clearer picture of our financial health. Revenue is recorded when the service is earned, not when the money exchanges hands. This is especially important for the many projects for which we receive payment in installments.
A wedding shoot from last month, for example, had a 50% deposit at the time the package was booked and then the balance was due 30 days after delivery.
A cash-based accounting system wouldn’t reflect the first part of the payment until the client pays the rest, leading to an inaccurate picture of the income derived that month. Accrual accounting shows the full value of the project when the service was rendered.
Importantly, cash flow is only half the picture – accrual accounting also keeps track of expenses that haven’t been paid yet but for which we owe money.
This gives us a heads-up and means we won’t suddenly run out of cash. For instance, we pay our rent for our studio every month in advance, so we accrue the amount of the next payment every month while we wait to pay.
This way, we make sure that we have money for the rent when it’s due. Otherwise, we could find ourselves short of cash when a large, unexpected expense comes due.
However, accrual accounting is often more complex to manage, especially for smaller businesses. Our experience, though, has been that the benefits of accrual accounting outweigh the complexities of the initial setup.
For example, we invested in accounting software designed for accrual systems, and, with that, the complexity of accrual accounting washed away.
The bottom line is that the best option for you depends on the size of your business, its complexity, and your comfort with financial management.
When you’re a service business, like mine, involved in projects that generate income over time, and where payments often come in at different times as well, accrual accounting provides a much better picture of the actual health of the business.
It informs good financial decision-making, manages cash flow better, and helps with planning for future growth.”
Which One is Most Suited for You?
Are you eager to know which accon=unting method to choose? I will tell you this-
If you are a single-person owner of any company or organization or own a small enterprise with revenue below $25 million, you must opt for cash accounting. I recommend this because it’s very easy to understand and to imply, so is quite popular with new and upcoming businesses.
However, if you have had $25 million in annual revenue for three consecutive years, you are bound to use the accrual method as mentioned by the FASB. This is a more complicated process that requires expert help to be seamless
Let me elaborate a bit more on both types of accounting-
Cash-based Accounting
Cash basis accounting is very straightforward. How? It only records expenses and incomes when they are reflected in your account. For example, suppose you buy a product in September on credit from your company account, but the product gets delivered in October, and the money is deducted in October. In that case, the record will note it as an October expense. But this shows that your company had no business in September, whereas you did have a business; the payment came later.
The same goes for income. If you provide a service to a customer but receive payment two months later, the system will record it in the month it is received.
Accrual Accounting
The accrual method functions differently; this system records every time a service/product is billed and money is earned. If you do work and it is billed in September, accrual methods record it for September, no matter when the money comes into your account. Even if the payment is not received and your account is yet to reflect the amount, it can keep track of that.
This gives a more holistic picture of the company’s finances because it looks at all kinds of payments, even the ones stuck in the pipeline or the outgoing payments that will leave your accounts very soon. Hence, this method can help better prepare the company’s budgeting and forecasting system.
Russell Rosario, a CPA and Co-Founder of Profit Leap, talked to the Canada Hustle team about choosing accrual accounting over cash accounting. Here is what he had to say:
“Cash accounting is ideal for straightforward operations where transactions are immediate and easy to track. For example, a local bakery looking to manage daily expenses and understand cash on hand without complicated ledgers would benefit from this.
It’s simpler when it comes to tax filing, particularly for businesses with lower revenue thresholds.
Accrual accounting provides a comprehensive picture of a business’s financial health. It records revenues and expenses when they are earned or incurred, not just when cash is exchanged.
For a graphic design studio working on long-term projects, accrual accounting aligns revenues with related costs, giving a better sense of profitability over time.
his method is often required if you’re seeking external investment or aiming for significant growth, as it complies with GAAP and provides stakeholders with detailed, accurate financial reports.
When consulting businesses, I assess complexity, growth plans, and financial reporting needs. A tech startup, for instance, often benefits from accrual accounting due to investor expectations and the need for accurate future earnings projections.
On the other hand, a small retail store might stick with cash accounting to ease day-to-day bookkeeping and tax processes. The choice boils down to whether your business needs simplicity and immediate cash visibility or a detailed, strategic financial perspective.”
Check Out the Pros and Cons of Accrual Accounting
Let us determine the pros and cons of accrual accounting to help you choose which is better for your business.
Pros
- Creates a more accurate financial report for the company- helps you understand the customer buying and spending patterns.
- All GAAP guidelines are followed when you do accrual accounting.
- If you start using accrual accounting from the start of your business, you will never have to change the process, even if you scale up your business process.
Cons
- Requires a lot of resources and in-depth accounting knowledge. You will also need expert accounting help to smoothen the process.
- The biggest fault of this system is that it can give you an unclear picture of your cash in hand, which can be a financial disruption for a small business.
You Should Also Know More about Cash Accounting
What are the pros and cons of cash-based accounting? Check them out.
Pros
- The process is simple, and small businesses can figure it out quickly. Hence, it uses fewer resources and saves money.
- It helps with tax payments, too. Say you pay your taxes in April and have work done in April, but the payment in June does not have to be filed in the same financial year. You can easily file this income in the next tax bracket.
Cons
- It does not have a holistic financial picture because it does not record business transactions when they happen but only when payments come through. No payments in the pipeline can be figured out from this system.
- The cash basis system keeps no records of the Accounts Payable and Accounts Receivable systems. It can become a problem to retrieve and track payments if you do not have the actual dates of payments.
- If by any chance your business exceeds the $25 million mark, you will be again required to shift to the GAAP guideline-based system and revamp your whole business process overview.
We interviewed Nischay Rawal, CPA and Founder of NR Tax & Consulting, on this. Here is an excerpt from the interview:
“Cash accounting is straightforward and ideal for small businesses with simple transactions. For instance, a local boutique might prefer cash accounting to easily track daily sales and expenses, providing a clear snapshot of cash flow.
This method simplifies financial management and tax preparation, making it easier to handle day-to-day operations without complex financial statements.
On the other hand, accrual accounting offers a more comprehensive view of a business’s financial health by recognizing income and expenses when they are incurred, not when cash is exchanged.
For example, a technology startup developing software over several months would benefit from accrual accounting to align project revenues with related costs, giving a more precise picture of profitability and future earnings.
This approach is essential for businesses seeking external financing or investor interest, as it adheres to Generally Accepted Accounting Principles (GAAP). When advising clients, I consider the complexity of their operations, growth ambitions, and the need for detailed financial reporting.
A fast-growing consultancy firm would likely find accrual accounting beneficial for strategic planning and managing long-term contracts.
Conversely, a solo-operated landscaping business might opt for cash accounting to keep things simple and maintain immediate visibility of cash in hand.”
How do you Choose the Right Option for Your Business?
For small companies that do not have a significant cash flow and major inventory to work with, it is always better for them to use the cash-based accounting method to avoid any more complicated and detailed bookkeeping processes. But if you work with a bulk inventory and complex business process with multiple stakeholders, it is best to go with accrual accounting to keep the process more transparent.
For more clarity, better watch this video:
Guest Author: Saket Kumar
Last Updated on May 19, 2024 by Saket