We’ll look at both methods in detail, and how each one would affect your business.
Prefer watching? Explore Cash Basis VS Accrual Accounting in under 1 minute (Youtube video)
What is cash basis accounting?
Many small businesses opt to use the cash basis of accounting because it is simple to maintain. It’s easy to determine when a transaction has occurred (the money is in the bank or out of the bank) and there is no need to track receivables or payables.
The cash method is also beneficial in terms of tracking how much cash the business actually has at any given time; all you have to do is look at your bank account balance.
In addition, since transactions aren't recorded until the cash is received or paid, the business's income isn't taxed until it's in the bank.
To summarize, here’s a quick overview of the pros and cons of cash basis accounting:
Pros of cash-basis accounting:
- Simplest method of accounting
- Quickly shows you how much cash you have on hand at any given time
- Allows you additional control over your expenses and income for tax purposes, since transactions aren’t recorded until money is either in or out of the account.
Cons of cash-basis accounting:
- Does not show you your business’s liabilities, or the liabilities customers owe your business. Therefore, you could believe your business is financially stronger (or weaker, if you have several outstanding invoices) than it actually is.
- Only certain types of businesses are allowed to use cash-basis accounting, per the IRS. You cannot use this method if you offer customers credit; if your gross receipts are above the IRS requirement of $30,000,000 on average over the three prior tax years; or if you need to keep inventory on hand to account for income.
- Can be difficult to switch to accrual, if you decide to change or you are required to change as your business grows.
What is accrual basis accounting?
In accrual accounting, revenues and expenses are recorded when they are earned, regardless of when the money is actually received or paid.
For example, if you completed a project for a client in February, but the client did not pay you until April, revenue from that project would still be recorded in February—even though the cash doesn’t come in until 60 days later. Because this method gives you a more complete picture of your business’s finances, it’s more commonly used than the cash method.
In addition, because many businesses end up needing to switch over to the accrual method as they grow, or because they want to take on investors, it can make a lot of sense to start with accrual from the outset.
One important thing to note, however, is that accrual basis accounting does not give you an accurate picture of your cash flow. If you use accrual accounting, you’ll need to keep a close eye on cash flow in order to avoid potentially devastating consequences.
Note that some businesses do their bookkeeping on a cash basis but file taxes on an accrual basis. They take the steps to convert cash basis accounting to accrual basis once it's time to do tax prep.
Here’s a brief overview of the pros and cons of accrual accounting:
- Presents a more accurate, transparent picture of your business’s finances
- Helps you make better long-term decisions
- Avoids the necessity of switching over from cash basis accounting as your business grows or at tax time
- More complicated than cash basis accounting, and can require the help of a professional bookkeeping service or accountant.
- Opens up risks of internal fraud more than cash-basis accounting, so requires a system of controls
What it means to “record transactions”
he cash and accrual methods each require you to record transactions at different times. But what does it actually mean to record a transaction?
Every business has to record, or write down, all its financial transactions in a ledger, a process that’s known as bookkeeping. This used to be done by hand on paper, but now business owners mainly do this using bookkeeping software.
You'll need to do this if you want to claim expenses at the end of the year. And you'll need one central place to add up all your income and expenses (you'll need this info to file your taxes).
There are some good DIY bookkeeping options out there. Or if you'd rather have someone else do your bookkeeping for you, check out Bench.
Diagram comparing accrual and cash accounting
A real world example showing the differences between cash and accrual accounting
Let's look at an example of how cash and accrual accounting affect the bottom line differently. We’ll use a hypothetical web design company, and examine a month of transactions.
Imagine you perform the following transactions in a month of business:
- Send out an invoice for $5,000 for a web design project completed this month
- Receive a bill for $1,000 in developer fees for work done this month
- Pay $75 in fees for a bill you received last month
- Receive $1,000 from a client for a project that was invoiced last month
Using the cash basis method, the profit for this month would be $925 ($1,000 in income minus $75 in fees).
Using the accrual method, the profit for this month would be $4,000 ($5,000 in income minus $1,000 in developer fees).
As you can see, the two methods result in very different numbers. These differences hold true for when it’s time to do taxes, as well—let’s take a look at how different this web company’s taxes would look if they use the cash method or accrual method.
How cash vs accrual accounting affects your taxes
One of the most significant differences between cash and accrual accounting is that each method affects which tax year your income and expenses are recorded in.
As a refresher, in cash basis accounting, income is recorded when you receive it. With the accrual method, income is recorded when you earn it.
To illustrate how this affects taxes, let’s imagine that the transactions above took place between November and December of 2023. Using accrual accounting, if you invoice a client for $5,000 in December of 2023, you would record that transaction as a part of your 2023 income (and thus pay taxes on it), even if you end up receiving the payment in January of 2024.
If you use cash basis, you won’t record the transaction until the payment comes in, and it will become part of your 2024 taxable income.
Further Reading: A Small Business Tax Checklist
Cash basis and accrual accounting in software
Many accounting software platforms offer users the option to choose either cash or accrual basis accounting.
In Quickbooks, you can choose either Cash or Accrual as your accounting method. You can also run reports that use either method, so you can compare how your finances look with each.
Wave also offers both cash and accrual, although accrual is the default method for reporting. You can switch to cash by simply choosing the option in the Report Type menu.
Bench, which uses both software and human bookkeepers, also offers both methods, with cash basis being the default. You can request accrual adjustments for your bookkeeping if needed.
Should a small business use cash or accrual accounting?
If your business doesn’t hit those criteria, you’re welcome to use the cash method.
That being said, the cash method usually works better for smaller businesses that don’t carry inventory. If you’re an inventory-heavy business, your accountant will probably recommend you go with the accrual method.
To change accounting methods, you need to file Form 3115 to get approval from the IRS.
(If you’re in Canada, the CRA offers guidance on how to change methods here.)
Further Reading: Small Business Accounting 101: A Guide for New Entrepreneurs