As a financial services firm that helps our clients with all aspects of their accounting needs (from bookkeeping to accounting processes, like expense or AP management, to CFO projects), our clients ask us a lot of different questions.
However, a common topic we discuss at the beginning of our engagement is around accounting methods… what is the difference between Accrual vs. Cash? Why does it matter? And how does it benefit me?
Great questions – here is how we break it down….
First, accrual accounting and cash accounting are two methods of accounting used in business. Both methods are used to record financial transactions, but they differ in terms of when revenue and expenses are recognized (i.e. show up on your Profit and Loss report). In this breakdown, we will explore the differences between accrual accounting, cash accounting, and the option of using your accounting software to help with a more clear financial picture (or as we call it “Accrual Lite”).
Accrual Accounting
Accrual accounting (also commonly known as GAAP accounting) is a method of accounting that records revenue and expenses when they are earned or incurred, regardless of when the money is received or paid. It is all about the “timing” of when income and expenses show up on your Profit and Loss statement to give you a better idea of your actual profitability. For example, if a company provides services to a customer in December but does not receive payment until January, the revenue will still be recognized in December (when the work was done). Similarly, expenses are recognized when they are incurred, even if the payment has not been made. For example, if a company purchases supplies in December but does not pay for them until January, the expense will still be recognized in December.
Accounts Receivables and Accounts Payable are the two categories that play the largest role in Accrual accounting for simple businesses. Some more complicated examples might be spreading out the cost of large purchases that are paid annually over the entire year or spreading out income from a customer’s purchase over the period of their prepaid contract.
Accrual accounting provides a more accurate picture of a company’s profit, as it takes into account all revenue and expenses, regardless of when the money is received or paid. As a business becomes larger and more complex, this may become essential to understanding the financial story and potentially even mandatory (like in publicly traded companies or for tax purposes). However, it is much more complex and time-consuming than cash accounting.
Benefits of Accrual Accounting:
- Provides a more accurate picture of true profitability
- Helps businesses better manage cash flow by recognizing revenue and expenses when they are earned or incurred
- Allows businesses to track accounts receivable and accounts payable, which can help with forecasting future cash flows
- Can help businesses make better-informed decisions based on more accurate financial information
Drawbacks of Accrual Accounting:
- More complex and time-consuming than cash accounting
- May not be necessary for small businesses with simple financial transactions
- Can be more difficult to understand for those without accounting experience
Cash Accounting
Cash accounting is a method of accounting that records revenue and expenses when cash is received or paid. This method of accounting is based on the cash basis principle, which states that revenue and expenses should be recognized when the cash is received or paid.
In cash accounting, revenue is recognized when the payment is received, and expenses are recognized when the payment is made. For example, if a company provides services to a customer in December but does not receive payment until January, the revenue will be recognized in January. Similarly, if a company purchases supplies in December but does not pay for them until January, the expense will be recognized in January.
Cash accounting is simpler and easier to use than accrual accounting, but it may not provide an accurate picture of a company’s financial position, as it does not take into account revenue and expenses that have been earned or incurred but not yet paid. Most small businesses file their business tax returns on a cash basis due to the simplicity (another conversation to have with your CPA), but many still maintain their books in accrual to better manage their business (as we discuss below).
Benefits of Cash Accounting:
- Simpler and easier to use than accrual accounting
- Better suited for small businesses with simple financial transactions
- Aligns with the way most small businesses file their tax returns
Drawbacks of Cash Accounting:
- Does not provide an accurate picture of a company’s true profit
- Does not take into account revenue and expenses that have been earned or incurred but not yet paid
- Can make it more difficult to manage cash flow, as revenue and expenses are recognized when cash is received or paid, not when they are earned or incurred
Accrual “Lite” (an unofficial Accountix term)
But, what if a business wants to see the details that accrual accounting provides yet they do not need to file their tax returns with that requirement and are under no obligation to keep GAAP financials?
Enter the concept of “accrual lite”.
Accountix recognizes the benefit of using the accrual accounting method however, most small businesses do not need to maintain GAAP-level accrual methods. Therefore, Accountix will consult with you on creating a hybrid between accrual and cash basis that provides an excellent value. Typically this means keeping the books up to date and recording the transactions in QuickBooks Online’s accrual manner (this includes tracking AR and AP accordingly). Accountix will also determine if any advanced accrual methods might be worth the additional cost from a management standpoint. If so, we may implement further accrual methods that are worth the “cost”. The company will continue to file the tax returns with their CPA on a cash basis as the transactions can be converted from Accrual to Cash basis easily each tax year.
This modified process provides the benefit for business owners to understand a more complete financial picture while maintaining a more simplified tax filing requirement and without the level of cost and sophistication of GAAP-level accrual accounting. Our clients appreciate having the best of both worlds!
Benefits of Accrual “Lite”:
- Provides a more complete financial picture for business owners in the areas that matter most
- Helps businesses better manage cash flow by recognizing revenue and expenses when they are earned or incurred
- Allows businesses to track accounts receivable and accounts payable, which can help with forecasting future cash flows
- Can help businesses make better-informed decisions based on more accurate financial information
- Maintains a simplified tax filing requirement
Drawbacks of Accrual “Lite”:
- May still be more complex and time-consuming than cash accounting
- May not be necessary for small businesses with very simple financial transactions
- Can be slightly more difficult to understand for those without accounting experience
In conclusion, the choice between accrual accounting, cash accounting, or a mix of both (Accrual Lite), depends on the needs of the business and the nature of its financial transactions. While we recommend you consult with your tax professional or accountant to finalize which method is best suited for your needs, Accountix is here to discuss your options and work with your CPA to see what benefits you and your business the most.