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Cash vs Accrual Accounting: An Entrepreneur’s Guide to Choosing the Right Accounting Method

By November 1, 2023 No Comments

Imagine scaling your business successfully, only to find that your accounting method is holding you back. 

Choosing between cash vs accrual accounting is more than just bookkeeping—it can shape your business’s financial stability, impacting cash flow, operations, growth prospects, and long-term planning.

Cash accounting offers immediate insights into cash flow but may limit long-term planning and access to capital. Accrual accounting is a more complex accounting process, however, it provides a more accurate view of profitability, which can help attract investors and help you make better business decisions.

Keep on reading as we explore the pros, cons, and real-world implications of cash vs accrual accounting!

What is cash accounting?

Cash accounting, sometimes called cash basis accounting, is a simple way to track your business’s money. This accounting method recognizes:

  • Revenue when it’s received.
  • Expenses when they’re paid. 

There are no accounts receivable (what you’re owed) or accounts payable (what you owe) in cash accounting. In other words, financial transactions are recorded only when money changes hands.

So, cash accounting is great for small businesses with only a few daily transactions because it’s easy to manage independently or with a bookkeeper. It helps you make decisions based on the money you have, which is important for everyday expenses.

Applying cash accounting: A graphic designer

Let’s take Sarah, a graphic designer juggling projects for small businesses and entrepreneurs. Imagine she’s recently wrapped up a logo design project. How does cash accounting play a role in her financial management? Let’s break it down:

Sarah finishes a logo design for a client on December 21, 2022. The client transfers $500 to Sarah on January 5, 2023, as payment for her work.

In addition, Sarah subscribes to a stock photo service in December, an expense totaling $50. However, she pays for this subscription on January 15, 2023.

Cash accounting in action:

Income Recognition:
Sarah records the $500 income on January 5, 2023, the day she actually receives the payment.

Expense Recording: Similarly, the $50 expense for the stock photo subscription is logged on January 15, 2023, aligning with the payment date.

Managing Cash Flow: With cash accounting, Sarah efficiently monitors her cash flow. This method provides a clear picture of her available funds, essential for managing expenses and investing in her business. In January, her records show a net gain: $500 in income against a $50 expense.

Tax Implications: A key aspect of cash accounting is its impact on tax liability. For Sarah, the income from the project completed in December 2022 isn’t taxed in the same year. Since the payment was received in 2023, she’ll account for this income in her 2023 tax filings.

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What is accrual accounting?

Now, let’s take a look at accrual accounting, also known as accrual basis accounting. This method uses revenue recognition to log financial activity regardless of when cash changes hands.

This means that instead of recording the money when it comes in and goes out, accrual accounting records:

  • Revenue when it is earned.
  • Expenses when they are incurred.

With accrual accounting, you record revenue when a product or service is delivered, even if the customer has not paid cash for it yet. You also record expenses as they’re incurred, even if you haven’t paid for them yet.

So, how does this affect your business? Well, accrual accounting can give you a more complete picture of your financial position than cash accounting because it allows you to see future expenses and income instead of current ones.

For instance, if you made a sale to a customer in January, but you won’t receive the payment until May, your financial records will reflect this sale in your accounts receivable. Similarly, if you have a bill due in two months, it will be listed under accounts payable.

In both cases, this insight can help you manage your finances more confidently and plan more effectively.

Applying accrual accounting: A wholesale candle company

Picture a company named Bean Counters Candles, a wholesale candle company that sells candles to retail stores. In December 2023, they sell a large batch of candles but don’t get paid for it until January 2024.

Here’s how they handle this using accrual accounting:

When they make the sale

  • Bean Counters Candles records $60,000 as income in December 2023, even though they haven’t received the money yet.
  • In their books, they note that the retail store owes them $60,000 and also recognize this as part of their sales revenue.

Handling the costs

  • Making candles costs money. Bean Counters Candles spent $5,000 on making the batch they sold.
  • They record this $5,000 as an expense in December, reducing the value of their remaining stock.

Getting paid

  • Fast forward to January 2024, the retail store pays the $60,000 invoice.
  • Bean Counters Candles then adjusts their records to show they’ve received the money and no longer have the $60,000 receivable.

Why this matters

  • By using accrual accounting, the company can show that they made a profit in December, even though they got the cash later.
  • This method gives a clear picture of the company’s financial status during a specific time period.
  • For tax purposes, Bean Counters Candles will report the $60,000 income for 2023, because that’s when they made the sale.

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Advantages and disadvantages of cash accounting

Let’s look at some pros and cons of cash accounting and how it can impact your business’s bottom line.

Pros of cash method

  • Simplicity: Cash accounting is straightforward and user-friendly, ideal for entrepreneurs with limited accounting experience.
  • Tax Efficiency: You pay taxes only on the income you’ve actually received, potentially reducing short-term tax liabilities.
  • Time-Saving: It involves less tracking, focusing only on actual cash transactions, unlike accrual accounting, which requires monitoring receivables and payables.
  • Clear Cash Flow View: Offers a real-time snapshot of your available funds by recording transactions when cash is exchanged.

Cons of cash method

  • Limited Financial Insight: This method doesn’t capture the full picture of financial health, overlooking receivables, payables, and future commitments.
  • Compliance Issues: May not meet certain legal and financial reporting standards, such as GAAP, especially for larger businesses.
  • Not Ideal for Inventory-Based Businesses: In cash accounting, inventory costs are recognized only upon sale, which can lead to misleading financial figures.
  • Revenue Constraints: Businesses with annual revenues exceeding $27 million are required by the IRS to adopt accrual accounting.

Advantages and disadvantages of accrual accounting

Now, let’s look at the pros and cons of accrual accounting and how it can impact your business’s bottom line.

Pros of accrual method

  • Comprehensive Financial Picture: Offers a more accurate picture of your financials by including all revenue and expenses, not just cash transactions.
  • Growth-Focused: Helps in making long-term decisions as it provides a more clear view of where your business stands financially.
  • Investor-Friendly: Preferred by investors for its detailed insights into business performance and long-term visibility.

Cons of accrual method

  • Complexity: Involves more detailed bookkeeping that follows accounting standards like GAAP, which often requires an accountant’s expertise.
  • Cash Flow Insight: While showing profitability on paper, it can be misleading about how much cash you actually have on hand since earnings are recorded before you receive them.
  • Higher Tax Liability: You might pay taxes on money you haven’t received yet since income is counted when earned, not when received.

Accrual vs cash: A side-by-side SaaS example

eManage, a SaaS company, sells 400 subscriptions for $150 each in October. Customers pay immediately and in full. In addition, eManage incurs $900 in hosting and marketing expenses each month.

Now, let’s look at how revenue and expenses are recognized using both methods:

Using cash accounting

  • Revenue: eManage records the total revenue of $60,000 (400 subscriptions x $150 = $60,000) in October when they receive subscription payments.
  • Expenses: eManage logs the $900 monthly expense for October when paid.
  • October Performance: With a revenue of $60,000 and expenses of $900, this results in a net profit of $59,100.

Using accrual accounting

  • Revenue: eManage spreads their subscription revenue over 12 months, recognizing $5,000 of revenue in October (400 subscriptions x $150 = $60,000 -> $60,000 / 12 = 5,000)
  • Expenses: eManage logs the $900 monthly expense when incurred.
  • October Performance: Revenue is $5,000, and expenses are $900, so net profit is $4,100.

Comparing the two methods

Using cash accounting, eManage records a big profit in October. This happens because it accounts for all of the revenue from subscription sales and the expenses paid within that month. This method shows a high profit when there are a lot of sales, but no profit when there are no sales.

On the flip side, accrual accounting spreads money out. It divides the subscription revenue over the entire year and records expenses when they’re incurred. With this even distribution,  eManage shows a steadier financial picture.

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So which method should you choose?

The cash vs accrual accounting debate is all about timing—specifically when you record expenses and revenue. This seemingly small difference can greatly impact managing your business’s finances.

Why? Well, the difference between the two methods can significantly affect how you handle your business’s money. Your financial planning, tax reporting, and even just decision making can vary a lot between the two methods.

And while it may seem like an either-or situation, you don’t have to limit yourself to one method! Many business owners find value in a mix of both, using the strengths of each method to fit their specific needs. The goal is to find what works best for you and your unique business.

For most businesses, it makes sense to stick with cash accounting for daily operations and accruals to manage credit cards, bills you owe, and money others owe you.

At Acuity, we believe in keeping things simple, so we recommend starting with the basics and implementing the cash accounting method. As your business grows, you can gradually add elements of accrual accounting to manage more complex financial scenarios.

If you’re still unsure which road to take, ask yourself questions about your business needs and goals. Consider:

  1. How big and complex is my business? Determine whether your transactions are simple or if your operations are more complicated. Simple = cash. Complicated = accrual.
  2. What are the accounting standards for my industry? Some industries have specific regulations and require accrual accounting.
  3. What is my business’s cash flow situation? Evaluate your cash flow needs. Can you handle recognizing revenue before you receive payment? Or recording expenses before you pay them?
  4. How does my business handle invoicing and bill payments? If your business frequently invoices clients or has outstanding bills, accrual accounting can offer a more accurate reflection of your financial standing.
  5. What are my long-term goals and financial planning needs? Think about your vision for your business. Will you need loans or investors in the future? How do you plan to manage your business’s finances long term? Accrual accounting provides better insights into your future financials and gives lenders and investors the visibility they need into your business’s financial health.

If you choose to adopt accrual accounting fully or partially, consider adding a controller to your team. This role complements your bookkeeper by handling the more complex aspects of financial management.

A little help goes a long way

Choosing the right accounting method is key to keeping your finances in check, growing your business, and staying on top of regulations.

If you’re not sure how to move forward with cash accounting, accrual accounting, or a mix of the two, reach out to our team of experts today! We’re here to be the sounding board you need on your journey to financial success.