Before beginning your bookkeeping journey, you must determine when to record transactions. Cash-basis accounting recognizes transactions when money is exchanged, while accrual accounting recognizes transactions when billed, regardless of whether the buyer has paid.
Each method comes with its advantages and disadvantages. Below, we discuss cash vs accrual accounting to help you determine which method suits your business best.
Cash vs Accrual Accounting Key Differences
The differences in transaction recognition rules affect how income is taxed, the effort required in recording, and whom each method suits. Below, we’ve provided a short table listing the key differences between cash and accrual accounting.
| Cash Accounting | Accrual Accounting | |
|---|---|---|
| Rules for Expenses | Record expenses once cash has been paid | Record expenses once billed by the vendor |
| Rules for Revenue | Record revenue once payments have been received | Record revenue once customers are billed |
| Effect on Taxes | Only taxes income that the business has earned in cash | Taxes all income reported, regardless of whether the amount is in the business’ hands |
| Best Use Cases | Best for sole proprietors and small businesses with no inventory | Required for businesses that are publicly traded, use credit, or carry inventory |
What is Cash Basis Accounting?
The rules of cash-basis accounting state that transactions should be recorded as money changes hands. This means recording expenses only when paid and recording revenue only when received.
Because cash accounting reports transactions only when cash is exchanged, it does not record accounts payable or receivable. Additionally, businesses that use cash accounting are not taxed until their income reaches their bank accounts.
Implementing cash accounting is easier and cheaper than implementing accrual accounting. Additionally, because it exclusively tracks cash paid and received, it provides a clearer picture of cash flow.
Additionally, cash accounting only taxes the income you already possess. In contrast, accrual accounting forces you to report income that you’re owed, which remains taxable even if your access to funds is delayed.
What is Accrual Accounting?
Accrual accounting operates by the matching principle, which states that expenses should be reported within the same accounting period as related revenue. This means recording revenues and expenses once they are incurred, regardless of whether cash has already been exchanged.
This method accounts for advances or delays in payment. For example, when you make advanced payments, accrual accounting allows you to recognize that the corresponding service has yet to be performed. It also acknowledges accounts payable and receivable for services rendered but not yet paid for.
Accrual accounting allows you to accommodate non-immediate modes of payment, such as credit. Additionally, it provides an accurate picture of financial health within each accounting period. Because the matching period requires that expenses be recognized within the same accounting period as corresponding revenues, accrual accounting shows the direct relationship between what you spent and what you earned.
For example, let’s say you took on multiple high-paying clients in February but chose to scale back in March. Should most clients choose to pay their bills in March, the cash accounting method would make March look more profitable than February. Accrual accounting would display accounts receivable, appropriately tying your revenue to your February labor.
Cash vs Accrual Accounting Example
Let’s say you run a small video editing company. Throughout two accounting periods, you incur the following transactions:
- January 2, 2024: You bill Client A $1,000 for editing services.
- January 10, 2024: You bill Client B $800 for editing services.
- January 15, 2024: You pay $22 for your monthly video editing software subscription.
- January 22, 2024: Client A pays their $1,000 bill.
- January 30, 2024: You receive a $600 electricity bill. It is due in February.
- February 5, 2024: Client B pays their $1,000 bill.
- February 10, 2024: You pay your $600 electricity bill from January.
- February 15, 2024: You pay another $22 for your monthly video editing software subscription.
In cash accounting, you would only recognize the transactions that involved cash exchange. This means:
- Your $22 software subscription payment will be recorded in your January journal.
- Client A’s $1,000 payment will be recorded in your January journal because they paid their bill within the month.
- Client B’s $800 payment will be recorded in your February journal. Even if they were charged in January, they paid in February.
- You record your $600 electric bill payment in your February journal.
- You record the second $22 bill in your February journal.
We’ve provided journal entry examples below to illustrate:
| Date | Account | Debit | Credit |
|---|---|---|---|
| 01-15-2024 | Software Expense (Expenses) | $22 | |
| Cash (Assets) | $22 | ||
| Video editing software subscription payment | |||
| 01-22-2024 | Cash (Assets) | $1,000 | |
| Sales Revenue (Revenue) | $1,000 | ||
| Rendered service to Client A | |||
| Date | Account | Debit | Credit |
|---|---|---|---|
| 02-05-2024 | Cash (Assets) | $1,000 | |
| Sales Revenue (Revenue) | $1,000 | ||
| Rendered service to Client B | |||
| 02-10-2024 | Utilities Expense (Expenses) | $600 | |
| Cash (Assets) | $600 | ||
| Paid January electric bill | |||
| 02-15-2024 | Software Expense (Expenses) | $22 | |
| Cash (Assets) | $22 | ||
| Video editing software subscription payment | |||
Meanwhile, accrual accounting recognizes transactions as they occur. This means:
- In January, you record your bill to Client A $1,000 as a debit to accounts receivable and a credit to revenue. Once it is paid, you add an entry to acknowledge the receipt of cash and the elimination of accounts receivable.
- Client B’s $800 bill is also a debit to accounts receivable and a credit to revenue. However, you must create an adjusting entry in February to acknowledge the receipt of cash.
- You record each $22 subscription payment as a debit to expenses and a credit to cash within their respective accounting periods.
- Your electric bill is a $600 debit to expenses and an equivalent credit to accounts payable. In February, you must create an adjusting entry to record the loss of cash and the elimination of accounts payable.
See the journal entry examples below for a clearer picture:
| Date | Account | Debit | Credit |
|---|---|---|---|
| 01-02-2024 | Accounts Receivable (Assets) | $1,000 | |
| Sales Revenue (Revenue) | $1,000 | ||
| Billed Client A for video editing services | |||
| 01-10-2024 | Accounts Receivable (Assets) | $800 | |
| Sales Revenue (Revenue) | $800 | ||
| Billed Client B for video editing services | |||
| 01-15-2024 | Software Expense (Expenses) | $22 | |
| Cash (Assets) | $22 | ||
| Video editing software subscription payment | |||
| 01-22-2024 | Cash (Assets) | $1,000 | |
| Accounts Receivable (Assets) | $1,000 | ||
| Received payment from Client A | |||
| 01-30-2024 | Utilities Expense (Expenses) | $600 | |
| Accounts Payable (Liabilities) | $600 | ||
| January electric bill | |||
| Date | Account | Debit | Credit |
|---|---|---|---|
| 02-05-2024 | Cash (Assets) | $800 | |
| Accounts Receivable (Assets) | $800 | ||
| Received payment from Client B | |||
| 02-10-2024 | Accounts Payable (Liabilities) | $600 | |
| Cash (Assets) | $600 | ||
| Paid January electric bill | |||
| 02-15-2024 | Software Expense (Expenses) | $22 | |
| Cash (Assets) | $22 | ||
| Video editing software subscription payment | |||
Cash vs Accrual Accounting Effect on Taxes
You are always taxed on any income you report. Because cash accounting only reports income you’ve already received, you only pay tax on what you have in your bank account.
Meanwhile, because accrual accounting requires you to report income as it is generated, you sometimes have to pay tax on income you have yet to receive.
When to Use Accrual Accounting over Cash Accounting
The cash accounting method involves fewer journal entries and thus requires less effort than the accrual accounting method. We recommend it for small businesses with no inventory. However, there are multiple situations where the accrual method is required. These include:
High-Revenue or Publicly Traded Companies
Generally accepted accounting principles (GAAP) require the accrual accounting method for reporting financial information if:
- You run a publicly-traded company
- You generate over $30 million in revenue over a three-year period
Companies That Make or Receive Credit Payments Frequently
Credit payments delay money exchange between parties. If you make or receive credit payments often, the cash method of accounting will give you an inaccurate picture of each accounting period’s profitability.
For example, let’s say you billed multiple clients for January. However, more than half of them paid their bills in February. Because you only record payments as you receive them, you might interpret February as more profitable than January despite incurring the revenues in January. With accrual accounting, you match your revenues to the accounting period you earned them.
Companies with Inventory
Cash accounting recognizes the cost of goods sold when the companies purchase materials. Meanwhile, the matching principle dictates that accrual accounting recognizes expenses — such as the cost of goods sold — within the same accounting period they generate revenue.
When you only record expenses as cash is paid, you might generate an inaccurate picture of profit and loss. For example, if you spend $3,000 upfront in January for inventory, but only sell these items in the following months, your books might mislead you into believing that you incurred major losses in January, and inflated profits in the months after.
Meanwhile, accrual accounting requires you to attach a cost of goods sold expense for every corresponding sale within the accounting period. The method reflects the relationship between expenses and revenues more accurately.
Get Expert Bookkeeping with EpicBooks
Each method of recording transactions has its own merits and drawbacks. To determine which is better for you, assess the needs of your business. If you want an accounting method that accommodates simple business operations, requires little effort, and shows cash flow clearly, cash accounting is best. However, accrual accounting is better suited for businesses that work with inventory, credit, or delayed payments.
Every business owner’s time should be dedicated to high-impact, growth-generating business activities. If the manual load of cash or accrual accounting has been shifting focus from business, consider outsourcing work to our experts at EpicBooks. Aside from keeping accurate records, we also help you prepare for tax season, optimize business budgets, and generate strategic financial insights.
Read the EpicBooks services page for more information!
FAQs
Does GAAP follow cash basis or accrual accounting?
Accrual accounting is preferred by GAAP and the International Financial Reporting Standards (IFRS) and is required for companies that are publicly traded or generate $30 million within a three-year period.
What is the most popular accounting method?
Because of its GAAP acceptance, accrual accounting has become standard practice for most businesses. Additionally, most businesses work with transactions involving delays or advances in cash exchange. The cash method of accounting fails to accommodate these types of transactions.
Can you switch between cash basis and accrual accounting?
You cannot employ cash and accrual accounting methods at the same time. However, you can shift to a new accounting method if you request permission from the appropriate tax offices. Because how you report financial information affects how you are taxed, you cannot proceed with the shift without approval from your tax office.
Echo Wang is an accomplished Canadian entrepreneur and the driving force behind EpicBooks, bringing a wealth of experience and a passion for excellence to the realm of bookkeeping.
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