The accounting method you choose to abide by within your business will have an impact on how your revenues are reported, and ultimately how your profits are reported on your financial statements.
In this article we will discuss the differences, as well as the benefits and downsides, of cash basis vs. accrual basis accounting.
Cash Basis vs. Accrual Basis Accounting: What's the Difference?
The difference between cash basis vs. accrual basis accounting is the time at which you record revenues and expenses.
A business using the cash basis method of accounting will only record revenue in their books when they actually receive the payment.
On the other hand, a business using the accrual basis method of accounting will record revenue immediately when it is earned.
Cash accounting is a very simple way of keeping a businesses financial records in order, however using accrual basis accounting gives you a much more accurate representation of how your business is performing.
Cash Basis vs. Accrual Basis Accounting Example
Let's assume you run a small commercial cleaning company in Miami, FL.
A new client approaches you on May 28th asking you to clean their office.
You accept this job and the new client agrees to pay you $700 for your cleaning services.
On May 29th you show up to the clients office and make it look brand new again.
Immediately after the job is completed, you send out an invoice to the client on the very same day that you finished cleaning his office.
However, your invoice allows the client 30 days to make payment before becoming past due.
Then, two weeks later on June 12th, the client completes the invoice by sending you the $700 that was owed to you.
Here's where the difference of cash basis vs. accrual basis comes into play.
If your business operates under the cash basis method of accounting then you would only record the $700 payment when the cash (payment) was actually received.
So in this case the revenue from the office cleaning client would be recorded in June if you were using cash basis accounting.
However, if your business is using the accrual basis method of accounting then the revenue would be recorded once the revenue was earned (when the job was completed).
So for this example the $700 of revenue from the office cleaning job would be recorded in the books on May 29th because that is when the job was actually completed and the revenue was earned.
Therefore, the difference between cash basis vs. accrual basis in this example is the difference between recording an extra $700 in revenue in May, compared to recording an extra $700 in revenue in June.
What is Cash Basis Accounting?
Cash basis accounting is a method of accounting in which revenues and expenses are only recorded in the books when money changes hands.
Therefore, invoices sent are not counted as revenue and bills received are not counted as expenses until they are settled.
Cash basis accounting is most commonly used by freelancers, independent contractors, and very small businesses that just want a simple way to keep track of their cash position without having to worry about accounts receivable and accounts payable.
Benefits of Cash Basis Accounting
Here are a few benefits of cash basis accounting:
- it's very simple
- it allows a business owner to easily keep track of their cash position
- you only have to pay taxes on money that you have received which can help with cashflow
Downsides of Cash Basis Accounting
Here a some of the downsides of using cash basis accounting:
- it is not always accurate as, for example, one month might show a large profit solely because you held off paying large bills until the following month
- it only gives you a day-to-day view of your finances
- some businesses are not allowed to use the cash basis accounting method per IRS rules
What is Accrual Basis Accounting?
Accrual basis accounting is an accounting method in which revenue is recorded when it is earned and expenses are recorded when they are incurred.
In other words, a business using accrual basis accounting would record revenue as soon as they raise an invoice and would record an expense as soon as they receive a bill.
When an invoice is sent, the amount would be recorded in the 'accounts receivable' account until the invoice payment is actually received, and the bill amount will be recorded in the 'accounts payable' account until the bill is paid.
Benefits of Accrual Basis Accounting
Here are a few of the benefits of accrual basis accounting:
- your financial data is much more accurate
- you have a much more clear picture of your business' financial performance and position
- you have the ability to make higher-level financial decisions
- it is much easier to apply for loans or investments when your books have been kept using the accrual method of accounting
Downsides of Accrual Basis Accounting
Here are several downsides of accrual basis accounting:
- there is more work involved with accrual basis accounting
- you may have to pay taxes before the customer has paid you since you record revenue when an invoice is sent
Cash Basis vs. Accrual Basis: Summary
Cash basis accounting is when you record revenues and expenses only when money actually changes hands, while with accrual basis accounting you would record revenue when an invoice is sent and you would record expenses when a bill is received.
The cash basis method of accounting is much more simple, making it perfect for freelancers and new small business owners, but the accrual method will give you a more accurate picture of your business' finances.
There are benefits and downsides for both accounting methods, however the accrual basis accounting method will allow you to have a better understanding of your true financial position compared to the cash basis method.
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