Accrual vs Cash-Basis Accounting
Accrual and cash-basis accounting are the two primary methods businesses use in tracking their income and expenses. However, depending on the size of your business and other factors, one accounting method may be better-suited than the other. By understanding the differences between each method, you can determine which is best for your company's needs.
Cash-Basis Accounting: Simple to implement, but can distort financials
With cash-basis accounting, income and expenses are recorded at the time cash is paid or received. For example, if a company sells and delivers $5,000 worth of product during the month of January, but the company collects all of that cash in February, the cash-basis of accounting would record the sale in February. The same goes for expenses paid out; these are recorded for the month in which money was paid for the good or service. So if the company prepaid its freight handler $1,000 in December to make January shipments, the expenses would be recorded in December under cash-basis accounting.
Accrual-Basis Accounting: More involved process, but leads to more meaningful financials
On the other hand, with accrual-basis accounting, income and expenses are recorded at the time revenue is recognized and expenses are incurred (but not necessarily cash received/paid). Taking the previous example, the company would record sales $5,000 of sales and $1,000 of expenses in January. As you can see the sales and related expenses are recorded in the same period, which is known as the “Matching Principle”. The Matching Principle as well as proper Revenue Recognition (see our earlier blog post on this topic) are two critical components of accrual accounting.
Which is Right for Your Business?
Generally speaking, accrual-basis accounting is going to provide more robust and meaningful financials vs. cash-basis accounting. U.S. Generally Accepted Accounting Principles (GAAP) recognizes accrual-basis as the only method of accounting and most stakeholders (e.g. investors, creditors) will require accrual-based financials. In addition, the IRS requires C-corporations earning >$5M of sales per year and/or inventory-based companies to use the accrual basis method for tax filing purposes.
That said, the accrual-basis requires more time and effort to implement than the cash-basis, so as a result, many small businesses (e.g. <$5M of sales and no inventory) use the cash-basis for their financials. Still, should you own a small businesses and opt to use the cash-basis method, it is important to understand that this method can sometimes be misleading in showing your long-term profits. For example, one month may appear to be profitable when, in reality, sales were quite low and there were simply a lot of existing customers making payments on past purchases.
Now that you have a better idea of the differences between accrual and cash accounting, you can make a better-informed decision. If you're still not sure which is best for you, we recommend that you speak further with your financial providers and advisors.
Useful Links on Accounting Methods: