What Is Accrual vs. Cash Accounting for Small Businesses?
Cash and accrual accounting are both legitimate forms of accounting. But is it better to use accrual vs. cash accounting for your small business? Let’s briefly define each method and then break them down with examples to help you consider which might be better for your business.
Cash vs. Accrual – what’s the difference?
Cash accounting records income and expenses only when cash is paid or received. It is the simplest method of accounting and is often used by sole practitioners and small businesses. Accrual accounting records transactions when they are incurred, regardless of when cash is exchanged. This generally means that financial impacts to the business are recorded in a more timely manner and offers a more accurate financial picture of the business.
What Are Two Types of Accruals?
Most accrued transactions fall under two categories:
- Revenue accruals: Revenue is considered earned when an agreed-upon product or service is fulfilled, regardless of when cash is received. For example, if your company has a $30k contract that is fulfilled evenly over 3 months, you can record $10k in revenue each month. This revenue accrual will increase your Accounts Receivable until the cash is received.
- Expense accruals: Goods or services that are received by your business but have yet to be paid for generate accrued expenses. This often happens when a company buys on credit and plans to pay the vendor at a later date. These expense accruals typically result in Accounts Payable until the vendor is paid.
Important Considerations for Accruals
While many accrual transactions are straightforward, some require sophisticated treatment and strict compliance with standards to perform correctly. Having access to the right experience and skills is critical to ensuring your books are correct. Here are a few things to consider when recording accrual transactions:
- Revenue: Revenue is among the most important measures of business health, and recording revenue accruals can get very complicated quickly when dealing with transactions such as customer contracts, subscriptions, partially fulfilled services, warranties, and even the timing and terms of shipping agreements. Standards like ASC 606 and IFRS 15 provide very specific guidelines for ensuring revenue is recorded correctly.
- Expenses: Expenses can be incurred in many different ways, each requiring unique treatments:
- Current Period Expenses (i.e. utilities): These expenses are both incurred and paid in the same period and are usually booked directly to expense with no accrual required.
- Prepaid Expenses (i.e. prepaid insurance or prepaid software licenses): These expenses haven’t yet been incurred, so the prepayment is recorded on your balance sheet as an asset named Prepaid Expenses, which is gradually reduced as you record the expense each month it covers.
- Accrued Expenses (i.e. property taxes): Accrued expenses are incurred, but not yet paid. By recording the expense as it is incurred with a corresponding payable, you more accurately reflect your financial position and protect your business from financial ‘surprises’ down the road.
What Is an Example of Cash Accounting?
Cash accounting is considered a basic streamlined approach, providing an up-to-date record of the cash you actually have on hand. It is important to note, however, that cash accounting may not provide a complete picture of a business’s financial performance, as it won’t include transactions that have been fulfilled but not yet paid.
Let’s say Jim sells handmade crafts at a local market. Under cash accounting, Jim only records transactions when cash is exchanged. When he purchases supplies for $20 and pays for them in cash, he records the $20 expense. If Jim doesn’t sell anything that month, he’ll show a $20 net loss.
When Jim sells a handmade necklace for $50 cash the following month, he would record the sale as revenue in the business’s financial records. If he didn’t have any additional raw material purchases that month, he would show $50 of revenue, which would also be his profit for that month.
This example helps illustrate the simplicity of cash accounting (no payable or receivables), but also a common drawback: the mismatched timing of revenues and expenses. While Jim’s 2-month cumulative financial picture will be correct ($50 revenue – $20 costs = $30 profit), Jim doesn’t have clarity around his true profitability along the way.
What Is an Example of Accrual Accounting?
Accrual accounting records transactions when they are earned rather than when payment is received.
For example, let’s say a solar company installs solar panels on the roof of a customer’s home for $20,000. The customer pays a deposit of $5,000 at the installation time, with the remaining $15,000 to be paid over the next year.
Using accrual accounting, the solar company would record the full $20,000 as revenue when installation is completed, even though only $5,000 has been received at that point. This is because the company has earned the revenue by completing the installation, regardless of when payment is received.
The solar company would also record the expenses associated with the installation, such as the cost of the solar panels and labor, when they are incurred. For example, if the solar panels cost $10,000 and the labor costs $5,000, the solar company would record the $15,000 in cost of goods sold when the installation is completed.
In this example, the solar company’s financial statements would show revenue of $20,000 and expenses of $15,000, resulting in a net profit of $5,000. When the customer pays the remaining balance of $15,000, the solar company would record that payment as a decrease in accounts receivable (the amount the customer owes) and an increase in cash.
Adopting the accrual accounting method, businesses can accurately reflect the company’s financial performance and track the full impact of transactions over the entire business relationship with the customer.
Should Small Businesses Use Cash or Accrual Accounting?
There are obvious advantages to both cash and accrual accounting, but which type is most advantageous for your small business? Let’s explore the pros and cons of cash vs. accrual accounting.
Accrual Accounting Pros
- Accrual accounting offers a more granular view of your company’s financial health, clearly showing how much profit was earned in a given period. This can be particularly important for businesses that operate with long-term transactions, as it allows them to see the impact of a transaction over the entire period of the business relationship rather than just when payment is received or made.
- It helps businesses manage their cash flow better. Accrual accounting can help businesses better predict and manage their cash flow by recording transactions as they occur, providing a clearer picture of when payments are expected to be received and when expenses are expected to be paid.
- It can make it easier to secure financing. Many lenders and investors prefer to see financial statements prepared using accrual accounting, as it provides a more accurate and comprehensive view of a business’s financial position. This can make it easier for companies to secure financing, as lenders and investors will have a clearer understanding of the business’s financial health.
- It can make it easier to compare the financial performance of a business over time. By recording transactions consistently, accrual accounting allows organizations to compare their financial performance from one period to another more easily. This can help identify trends and make informed business decisions.
Accrual Accounting Cons
- Accruals can be complicated. Accrual accounting may be more work than it’s worth if your business operates with very short-term transactions.
- Accrual accounting can be higher cost. Accrual accounting requires more sophisticated talent to ensure your books stay clean. While it can provide better insights, there is a cost to generating those insights.
Cash Accounting Pros
- Cash accounting is simple. Small businesses may choose to use cash accounting because it is a simpler process and easier to implement for most, as it is similar to how you might keep track of your personal finances.
- Cash accounting requires less record-keeping. It only involves tracking the actual cash flows of the business.
- Cash accounting is aligned with income taxes. It’s much easier to apply cash-based business records to cash-based personal income tax returns.
Cash Accounting Cons
- Cash accounting does not consider transactions that have not yet been paid.
- Cash accounting may not accurately reflect your business’s financial performance, especially when costs or revenues cross multiple periods.
- Cash accounting makes cash flow predictions more difficult.
Making your Final Decision
Deciding which method to use is an important decision, but one you don’t need to make by yourself. If you have any uncertainty about how these methods will impact either the current state of your business or where you expect your business to be in the future, it’s wise to get input from a qualified professional.
And, like so many aspects of life, setting up your business accounting correctly from the beginning will not only save a tremendous amount of time and money fixing issues later, but it will make running your business more effective and enjoyable along the way.
Contact Amplēo today so our financial experts can help you make the best decision for your business.