Cash vs. accrual accounting: Choosing a method for your small business
Presented by Chase for Business.
Quick insights
- Cash and accrual accounting are two primary methods for recording business finances, each offering unique advantages.
- Cash accounting records transactions when money changes hands, while accrual accounting records revenues and expenses the moment they are earned or incurred.
- The preferred accounting method for a small business depends on its size, goals and regulatory requirements.
Choosing how to track business finances can impact everything from tax obligations to securing a business loan. Whether a business is a freelance operation, a growing startup looking for investor funding or a retailer managing complex inventory, understanding the difference between cash and accrual accounting may provide context for selecting a method that aligns with daily operations and future plans.
In this article, we’ll dive into each of these accounting methods, how they differ and which one may be best for your business in its current state. Consult with an accounting professional for advice on your specific situation.
What is cash accounting and accrual accounting?
Cash and accrual accounting are two common approaches businesses use to record their financial activity. But how income and expenses are recorded differ depending on the method you use.
Cash accounting
Cash accounting is a method where a business records income only when it actually receives the money, and records expenses only when they are actually paid. For example, if you sent an invoice in January to a client, but they don’t pay the invoice until February, you would account for the income in February.
This method is often used by sole proprietors, freelancers and smaller businesses that don't carry inventory. Small business owners may prefer this method because it typically provides a clear picture of available cash in the bank and may be simpler to maintain than accrual accounting.
Accrual accounting
Accrual accounting records income and expenses when they are earned or incurred, regardless of when cash is received or expenses are paid. For example, if you sent an invoice to a client in January, you would account for the funds from that invoice in January, even if the client didn’t pay it that month. This method may provide a broader picture of a company's financial health by matching revenues with the expenses that generated them.
Accrual accounting is typically used by larger businesses, those with complex operations or companies that carry inventory. It is also often the method required by Generally Accepted Accounting Principles (GAAP)—the standard framework investors and lenders look for.
Key differences between cash and accrual accounting
Understanding the main differences between these two accounting methods may help provide clarity on which one aligns with your specific business operations. Some notable differences include:
- Timing of transactions: Cash accounting records revenue and expenses when cash changes hands (e.g., a client pays their invoice). Accrual accounting recognizes them when they are earned or incurred (e.g., the service is delivered, even if the client hasn't paid yet).
- Complexity: Cash accounting is often simpler to manage and easier to maintain, while accrual accounting requires more detailed tracking of accounts receivable and payable.
- Financial insights: Accrual accounting offers a broader representation of a company’s long-term financial position, while cash accounting provides an immediate view of the actual bank balance.
- Tax implications: Cash accounting may allow more flexibility for tax planning, while accrual accounting may be required by the IRS for larger businesses or those with inventory.
Advantages and disadvantages of each accounting method
Both cash and accrual accounting have benefits and potential drawbacks. Here is a closer look at each method:
Cash accounting
Cash accounting offers advantages for small business owners, primarily due to its simplicity and ease of use. Because transactions are recorded only when money actually changes hands, accounting records closely mirror your bank balance. This method also is often cost-effective, requiring less time and expertise to maintain without the need for complex software.
Despite its simplicity, cash accounting has some considerations. Most notably, it may provide a distorted view of long-term profitability. Since it does not track accounts receivable or accounts payable, businesses might experience blind spots regarding unpaid customer invoices or upcoming vendor bills. Furthermore, banks and investors typically prefer the accrual method, meaning cash accounting could limit the ability to secure financing.
Accrual accounting
Accrual accounting offers small business owners a comprehensive view of long-term profitability. Businesses can match revenues with the costs it took to generate them—such as buying wholesale materials in one month to sell as finished products in the next. This method is usually favored by banks and investors when you apply for a business loan.
The primary consideration of accrual accounting is its complexity. Businesses may need to invest in specialized accounting software or hire a professional bookkeeper. Additionally, it can create a disconnect regarding cash flow. The books might show a profit for the month, but if customers haven't paid their invoices yet, the actual bank balance could be lower.
Factors to consider when choosing an accounting method
Selecting between cash and accrual accounting is a decision that shapes a business’s financial management. Here are some factors you may want to consider:
- Business size and complexity: Larger businesses or those with inventory may benefit from accrual accounting, while smaller operations prefer the simplicity of cash accounting.
- Tax requirements: Some businesses are required by the IRS to use accrual accounting, especially if they exceed certain revenue thresholds or hold inventory.
- Financial reporting needs: Accrual accounting provides detailed insights for tracking long-term trends and making strategic decisions.
- Cash flow management: If monitoring the day-to-day cash position is a priority, cash accounting typically makes this task more straightforward.
- Growth plans: Businesses planning to expand or seek outside financing often opt for accrual accounting to present a clearer picture to lenders.
Can you change from one accounting method to another?
Switching from cash to accrual accounting or vice versa is possible for many businesses. However, the process requires careful planning and approval from the IRS.
A change in accounting method is requested by filing IRS Form 3115 and following specific guidelines. Speaking with a tax professional or accountant is a common step before making any changes to an accounting approach.
Frequently asked questions
What happens if a client is invoiced in December but pays in January under cash accounting?
Under cash accounting, income is only recorded when the money is actually received. The payment received in January is recorded as income for the new year rather than the previous year. This means taxes on that specific income are tied to the year the cash was received.
Do banks require accrual accounting for business loans?
Many banks and investors prefer or require accrual accounting when evaluating loan applications. This method provides a comprehensive view of long-term profitability and overall financial health. Lenders use this detailed financial data to assess the risk of providing capital to a growing business.
How do businesses manage cash flow when accrual accounting shows a profit but the bank account is lower?
A common approach is utilizing a cash flow statement to track actual money moving in and out of the business. Some businesses also use financial tools like a business line of credit to bridge the gap between billing clients and receiving payments. These strategies may help maintain daily operations while waiting for outstanding invoices to clear.
When does the IRS require a business to use accrual accounting?
The IRS generally requires businesses to use the accrual method if they maintain inventory or exceed specific annual gross receipt thresholds. These thresholds are subject to change based on current tax laws and specific business structures. Consulting IRS guidelines or a tax professional provides clarity on the exact requirements for a specific business entity.
