Cash vs. Accrual Accounting: Pros & Cons
For many small business owners, accounting can seem like a labyrinth filled with confusing rules and terminology. Luckily, it can be broken down into two basic methods: cash and accrual. Most businesses prefer to operate using the accrual method, but some small businesses prefer the cash method for its simplicity. Choosing which method is right for your business depends on your business’s size, resources, and goals.
Cash Accounting Method
When it comes to cash vs. accrual accounting, cash is the simplest. When money comes in, it’s added to the ledger. When it leaves, it’s subtracted. It doesn’t rely on accounts receivables or accounts payables to keep track of money owed.
Let’s say you finished building a website for a client and sent them an invoice for $2,000. If your business uses the cash accounting method, that $2,000 won’t be added to your books until that money is deposited in the bank, even if it’s a month or two later. The same goes for expenses. They shouldn’t be recorded until the money leaves your account.
Benefits of Cash Accounting
The main benefit of using cash accounting practices is its simplicity. You don’t need an advanced degree to add and subtract income and payments. All the math is straightforward, you don’t need to track accounts receivables and payables, and the ledger is easy to read. It’s also easy to see where your business stands financially at any given time and calculate cash flow metrics.
Disadvantages of Cash Accounting
With simplicity, usually comes a lack of detail. The cash accounting method is excellent for seeing the financial health of your company at a given time, but it fails to provide a complete picture.
What if your business earned $10,000 in March, but there are two other unpaid invoices for $15,000 sent out in the same month? According to the books, your business might only show $10,000 in revenue for March, when, in reality, you earned $25,000. That extra $15,000 billed in March will count towards the revenue of another month, making it seem stronger than it actually was.
Accrual Accounting Method
The accrual accounting method is the more popular of the two, and conforms to the Generally Accepted Accounting Principles, or GAAP. While it may be more complicated than the cash method, it provides a more accurate account of a company’s overall financial health.
For this method, income and expenses are recorded when they are billed and incurred instead of when the money changes hands. In the example above, the $2,000 you billed to the client for their website would be added to the books once the project is complete and the invoice sent. Even if the customer doesn’t pay until next month, that money would be considered income as soon as it’s billed.
Benefits of Accrual Accounting
Because it offers more detailed insights into your company’s finances, accrual accounting provides a better long-term financial view. You will be able to see exactly how much money was earned and spent at a given time, despite payment dates. This insight will help you to create a better plan based on highs and lows throughout the year.
Accrual accounting also conforms to GAAP and is required by all companies that make more than $25 million annually. While $25 million is a lofty goal for small businesses, choosing the accrual method means that you won’t have to change your accounting method in the future due to expansion. Accrual accounting is also required by some banks regardless of business income.
Disadvantages of Accrual Accounting
Accrual accounting is more complicated, which requires more time and resources that most small business owners don’t have to spare. It involves the tracking of cash flow, accounts receivables, and accounts payables.
It can also skew the short-term financial view of your company. If you invoice $15,000 in a month, the accrual method will show that you earned all that money, even if you received zero. Your books would be showing more money than you have, which could affect paying bills or, worse, salaries.
How to Choose the Correct Method
When weighing the cash vs. accrual accounting advantages and disadvantages, it comes down to your business type, size, resources, and goals. If you own a very small, service-based business, using the cash accounting method would probably work better for you. There’s no inventory to track, and you’re most likely handling accounting responsibilities yourself. If you run a medium-sized retail company with dreams of expanding, you should probably be using the accrual method.
If you would like to have the benefits of the accrual accounting method but aren’t sure if you have the resources or skills necessary, many businesses choose to outsource accounting and bookkeeping to a professional. That way, your accounting can meet GAAP requirements without taking up any more of your precious time.
The IRS does require that businesses maintain the same accounting method to report annual taxes, so once you choose one, stick with it.
Download our free guide and learn more about growing your business through organized accounting procedures and software.