Cash vs. accrual accounting in a small business

As an owner, operator or investor in small to medium sized businesses (SMBs), a common problem that they must answer is deciphering financials based on the accounting method used. The two accounting methods available to small business owners are cash basis accounting (also known as the cash method) and accrual basis accounting (also known as the accrual method). Each accounting method has its own advantages and disadvantages. Thus, this blog post aims to explain what is cash accounting and accrual accounting, differences and similarities between cash accounting and accrual accounting, and any legal requirements for using one accounting method over the other.

What is Cash Accounting?

Cash accounting is a simplified accounting method. With cash accounting, the business reports revenues and expenses when cash is received or paid out. In other words, the cash that goes in and out of the businesses bank account is what is tracked for cash accounting.

What is Accrual Accounting?

Accrual accounting is a bit more complex than cash accounting. Revenues and expenses are accounted for as revenues are earned and expenses are incurred. In other words, common account items in accrual accounting are unearned revenues (deferred revenue) and prepaid expenses (prepaid insurance, prepaid rent, etc.).

Accrual accounting is the most common type of accounting method used among firms because as the business expands the Internal Revenue Service (IRS) will require the business to use accrual accounting.

Pros and Cons of Cash Accounting

Pros of cash accounting is that it is easy to use and therefore often less expensive to complete. Again, cash accounting is simply the exchange of cash. Thus, it requires the least work from bookkeepers, accountants and owners to use. At the end of the day, the movement of cash defines when revenue or expenses are recognized. This can lead to large swings in profitability, but it is the easiest to use off the bat.

However, a few cons to cash accounting is that it isn't a great tool if one is trying to forecast a business. Therefore, if the business is looking to expand, cash accounting doesn’t do a great job of detailing business performance. Moreover, if the business has gross receipts greater than $25 million then the IRS will require a business to use accrual accounting. Therefore, if the business was using cash accounting, but grew the business to have gross receipts greater than $25 million then the business would have to change its accounting method. Lastly, some lenders may require a business to use accrual accounting; therefore, if the business is using cash accounting then the business would not be able to borrow from that lender.

Pros and Cons of Accrual Accounting

Pros of accrual accounting is that the IRS requires it above a certain amount in gross receipts and if the companies are public, Generally Accepted Accounting Principles (GAAP) and the Securities Exchange Commission (SEC) will require accrual accounting. Therefore, if a business uses accrual accounting right away then from an accounting standpoint the business is ready to expand without many changes. Another positive is that accrual accounting provides a more complete picture of a businesses financial position and operations. In other words, accrual accounting does a better job at measuring a businesses profitability. If the business has inventory or uses a high amount of credit (accounts receivable and accounts payable) then accrual accounting is the preferred method because it will accurately track customer transactions and business operations.

Cons to accrual accounting is that it can be time consuming (higher costs to implement) and complex. It requires analyzing each transaction to understand when it should be recognized as revenue or an expense, as well as over what period. Accrual accounting can mask cash flow problems within the business because revenue and expenses are accounted for when they are earned or incurred, respectively. Practically, this means if you prepay for an annual expense, all of the cash leaves the bank on that day, but the profit-and-loss will only show the expense for that month.

When will cash and accrual accounting depict the same financial statements?

Cash and accrual accounting will be the same if the business is a 100% cash business. In other words, the business doesn’t use any sort of credit or debt within its business operations. In reality, this is rare because many businesses accept sales on credit or purchase inventory on credit. Nevertheless, if the business is operated with 100% cash then cash and accrual accounting financial statements will be the same.

Small Business Perspective

From a small business perspective, if there are thoughts of growth in the future or the business permits use of credit during sales or expenses then the accrual accounting may be the preferred accounting method. The accrual method would save owners, operators and investors significant time and money from having to convert a business from cash accounting to accrual accounting.

Lastly, accrual accounting is commonly used and recognized in the business world; therefore, investors, lenders, creditors, suppliers, etc. prefer accrual accounting to cash accounting. If the majority of businesses use accrual accounting then it is easier for lenders, creditors and investors to compare businesses to one another and it may make it easier for the business to receive funding.

Information posted on this page is not intended to be, and should not be construed as tax, legal, investment or accounting advice. You should consult your own tax, legal, investment and accounting advisors before engaging in any transaction.