Cash vs. accrual accounting: What’s best?

Have you ever wondered why your business bank account balance might not match your business' financial statements? It comes down to when one records revenue and expenses. Cash and accrual are the two most common accounting methods.

Even if you outsource your business' finances to a third party, knowing the difference between these two techniques is essential because one model might better suit your business’ structure.

Let’s look at how cash vs. accrual accounting works: the advantages and disadvantages of each and explain how each affects your business so you can select the right accounting method. 

Main takeaways

The core differences between these two accounting principles are timing and complexity. Cash basis accounting tends to record income the moment cash or payment is received. Accrual accounting recognizes revenue when the transaction occurs, not when money is received.  

What is cash basis accounting?

Cash basis accounting is also known as cash receipts and disbursements or checkbook accounting. Cash accounting recognizes revenue only when they receive payment or when it’s deposited in your bank account. Expenses are also recorded as and when they are paid. In simpler terms, it means that expenses are only recognized when the cash leaves your hands to go to suppliers, vendors, and other parties. 

The cash basis accounting method does not track inventory, accounts receivable, or accounts payable.
What is an example of cash basis accounting?

Let’s look at an example of how Julia, a freelance graphic designer, would record income for her business. Julia designs a logo and business cards for a client with a billing value of $2,000 in January. Julia won’t document the income until the client pays in March. 

For expenses, Julia purchased a new graphic pen in February and paid for it with her debit card. She will record the expense when money is debited from her bank account. 

From a cash flow perspective, Julia’s balance sheets for January and February will show a negative balance as she incurred expenses and recorded no income. When she receives her payment from her client in March, her cash flow will be positive. 

Advantages of cash basis accounting

Cash-based accounting offers several advantages, particularly for small businesses or those just starting out. Here are some of the key benefits.

• It is easier to understand and implement: Cash accounting is simple because transactions are only recorded when cash physically exchanges hands. The learning curve is pretty short, so one can start practicing it immediately. 
• Provides visibility on cash flow: Very small businesses or those just starting out can use this method to see how much cash is available at any given point. The business owner simply has to look at the bank statements to understand the business’ financial health and know when and what bills can be paid.
• Saves time, money, and effort: Its simplicity makes this accounting method more accessible and less time-consuming to track and maintain. Since there are no accounts payable and receivable, one can save on the overhead cost of hiring a bookkeeper or an accountant.
• Tax advantages: Since this method only tracks when cash is received or paid, it gives businesses more control over their income and expenses for tax purposes. For instance, some can delay recognizing income and potentially lower their tax obligations.

Limitations of cash basis accounting

On the flip side, the cash basis method of accounting does have some drawbacks. Here are a few.

• Overstates profitability: While knowing how much cash there is great, the cash basis accounting method doesn’t show your business’ liabilities or how much you owe. If you have several unpaid expenses, the balance sheet might indicate a stronger financial report than what it is. 

Here’s another example, if your company’s sales have been declining over a period, but you suddenly receive a large number of cash payments from customers, cash accounting will show an influx of cash and a jump in profitability. 

• Incomplete financial picture: As you don’t consider accounts receivable (you have sold a product but are yet to get paid for it) or accounts payable (you have incurred the expense but are yet to pay), it doesn’t provide an accurate picture of your company’s financials. 
• Difficult to scale: Scaling a business often comes with increased complexity, such as tracking inventory or a rise in credit. This method doesn’t factor those in.
• Tricky to compare periods: There's a mismatch in the timing of income and expenses in cash accounting. Therefore, it can be difficult to compare different quarters or years. For instance, one quarter might show high expenses because of a capital equipment purchase with no sales, while the next might show high revenue and no expenses because you have yet to pay the outstanding bills.
• Limited use: As per the IRS, certain businesses can only use cash basis accounting. You cannot use this accounting practice if you offer credit or have average annual gross receipts above $25 million for the past three years. 

Who uses cash basis accounting? 

Here are the types of businesses for whom cash basis accounting might be the better option: 

• Small businesses (including freelancers and sole proprietors) that primarily deal with cash transactions 
• Small businesses that have no inventory 
• Small businesses with limited financial transactions 
• Start-ups 
• Micro-businesses 

What is accrual basis accounting?

Accrual accounting recognizes revenue when a product is sold or a service is completed—not when cash comes into your hands. Expenses are recorded when they are incurred and not when you pay them off. 

• Accrual accounting uses accounts payable and accounts receivable.
• Accounts payable: Money that your business owes or has to pay
• Accounts receivable: Money that is yet to come in for products or services delivered by your business 

The Generally Accepted Accounting Principles (GAAP) outline the use of accrual accounting for businesses. It’s also the most commonly used accounting method for large enterprises and publicly traded companies. 

Example of accrual basis accounting

Here’s a quick example of how the accrual basis accounting method works. Let’s go back to Julia, our freelance graphic designer. Julia completed a website design project for a client in March but isn’t expected to get paid until June. Under accrual accounting, she will record revenue of $3,000 in March as she completed her work then, and that’s when the income was earned. 

For expenses, Julia pays for an annual subscription to a graphic design magazine in January for $500. Julia will record this as a prepaid expense in January and then spread an equal portion of the cost across 12 months. 

Advantages of accrual basis accounting

Here is why many businesses prefer the accrual accounting method for their financial reporting: 

• Provides a more accurate picture of the company’s financial health: Accrual accounting presents a more transparent insight into your business’ finances because it accounts for unpaid or earned billings and incurred expenses. It goes beyond just looking at cash flow. 
• Presents a complete balance sheet: As it factors in your company’s accounts receivables, accounts payable, inventory, fixed assets, and liabilities, it generates a complete balance sheet. 
• Gives a long-term view: Cash accounting provides a short-term view of your finances as it relies on how much cash is there. Accrual accounting is better for long-term planning and decision-making. 
• Easier to scale business: As your company grows to revenues over $25 million, you have inventory to manage, or the transactions get complicated, you will need to switch over to accrual accounting. It’s difficult to switch from cash to accrual accounting, so if you’re already using the accrual method, you’re set and don’t need to make adjustments.
• Helps with decision-making: Accrual accounting allows businesses to build more accurate budgets and forecasts. Business owners can make data-backed decisions around investment, resources, and growth plans by considering earned income alongside unpaid expenses. 
• Provides more credibility: Investors, external stakeholders, bankers, and creditors look at companies that use the accrual method for their financial statements more favorably as it follows GAAP. This could be crucial if you are seeking or planning for external funding. 

Disadvantages of accrual basis accounting

Here are a few drawbacks to adopting accrual accounting: 

• Long learning curve: The accrual method is more complicated to learn and implement. It’s also more time-consuming and difficult to match revenue with expenses. You might need to hire a bookkeeper or invest in accounting software to do it correctly. 
• Increased chances of errors: Understanding of GAAP is a must, and all recording of transactions must comply with the set guidelines. Because of its complexity, accrual accounting has a greater chance of mistakes in estimations and calculations, which can have grave tax consequences. 
• Doesn’t show cash flow: With accrual accounting, a company might appear to be profitable in the long run. For instance, you might have a lot of recorded revenue, but because it has not been paid, there could be a significant cash shortage. This is because the accrual method doesn’t track actual cash flow. 

Who uses accrual basis accounting? 

As mentioned earlier, accrual basis accounting is the more commonly adopted accounting practice. Here are a few more examples of businesses that use accrual accounts: 

• Large, enterprise-scale businesses
• Publicly traded companies
• Businesses with sales revenue over $25 million
• Businesses with inventory
• Businesses selling on credit
• Businesses seeking loans or external investments

Tax implications in cash and accrual accounting

Your choice of accounting methods can impact your tax burden. Let’s take a closer look at how income taxes are filed under each method. 

Tax implications with cash method of accounting 

Income and expenses are filed according to your cash flow with cash accounting. You will report income in the tax year you received the money. Likewise, costs will also be deducted in the year you paid them. 

Here’s an example: A small home bakery business that uses cash accounting completes a party order for $1,000 in December 2023 but doesn’t get paid until January 2024. The bakery will not record the income for its 2023 income tax returns, and it won't have to pay taxes on it.

Tax implications with the accrual method of accounting 

As we have highlighted, accrual accounting records revenue and expenses as they are earned and incurred. Therefore, the associated taxes must also be filed during the same accounting period.

If the small home bakery used the accrual method, they would include the $1,000 revenue as part of 2023’s taxable income. Likewise, any expenses incurred to complete that December party order would be deducted as business expenses for the same tax period. 

Tax laws and regulations are complex, and there are exceptions or specific rules that could apply to your industry or business size. Speak to a LegalZoom tax expert. They can explain which accounting method could give you more tax benefits and better suit your business.

Example of cash vs. accrual basis and how each impacts your bottom line

Let’s combine all that we’ve discussed and understand how your business’ balance sheets would look under each method. 

Your small photography business has the following transactions for April 2024: 

1. Paid $1,000 in studio rent
2. Received a payment of $500 from Client A
3. Received a photography magazine subscription bill for $40
4. Sent an invoice of $1,000 to Client B
5. Paid $200 for a new camera lens with company credit card 

Under the cash method, your business’ profit would be negative, indicating a loss. 

1. Profit = Income - expenses
2. Profit = $500 - ($1,000 +$200)
3. Profit = -$700

The cash method won’t account for the subscription bill of $40 because you didn’t pay for it in April 2024. 

With accrual accounting, your income statement would look slightly different. The profit would be $260, and here’s how it would work: 

1. Profit = Income - expenses
2. Profit = ($1,000 +$500) - ($1,000 +$200 +$40)
3. Profit = $1,500 - $1,240
4. Profit = $260

The accrual method of accounting would include the $40 bill for the magazine subscription as part of the month's accrued expenses, even if it hadn’t been paid. 

As you can see, there’s a vast difference in how each method reports company profitability. 

How to choose an accounting method for your business?

Cash basis accounting is a reliable and simple-to-use accounting method. It’s also easier to maintain and gives a quick insight into your company’s cash flow. 

However, the cash method might not depict the most accurate or updated picture of the company’s financial health. Before selecting one method over another, take the following factors into account. 

Size and complexity of business

If your small business’ annual sales are over $25 million, or you’re a publicly traded company or C corporation, then you must follow the accrual accounting method. 

Additionally, if your business has several bank accounts or multiple LLCs under a parent LLC, it’s advisable to choose accrual basis accounting. 

Business expansion plans

If your business plan doesn’t anticipate much growth over the upcoming years and you’re satisfied with the number of annual transactions, then cash basis accounting could be a better fit. 

However, if you foresee the number of transactions and their complexity increasing or anticipate annual revenue exceeding $25 million, it’s smarter to adopt accrual accounting from the get-go. It will save you from the headache of changing over later. 

Inventory

The IRS mandates that businesses with inventory follow the accrual basis method. Your inventory includes completed merchandise, raw materials, and work in progress. 

There are a few exceptions to this rule for certain small businesses, which an experienced tax consultant can explain. 

Whether business relies on credit

If your business deals with credit, which includes accepting customer’s credit card payments or paying your bills, then it’s better to adopt accrual accounting. 

Does the business require external funding?

Investors and financial institutions like banks prefer to work with businesses that use accrual accounting because it shows a more transparent and accurate snapshot of the company’s financial shape. Moreover, it communicates to external stakeholders that the company is financially astute and capable of expanding. So, if you anticipate getting a loan or funds from external stakeholders, pick accrual accounting. 

Here’s a quick recap: If your business deals primarily in cash, has no inventory, and has annual gross receipts under $25 million over the past three years, then the cash method would be the better and simpler option to follow. 

However, suppose your business deals with credit, has inventory, or has plans to seek funding from angel investors and other financial institutions, like banks. In that case, then accrual accounting will provide more benefits.

Remember that some companies must use the accrual accounting method for tax compliance purposes. Speak to a tax attorney or a certified public accountant (CPA) to understand whether your business falls into this category. 

FAQs on cash vs. accrual accounting

What is the main difference between the two methods? 

The main difference is the timing. Cash recognizes revenue and expense when the money is received or paid. Accrual factors in income and expenses during the time it’s earned. 

What is better for small businesses—cash or accrual accounting? 

This comes down to your business’ needs, size, and goals. If your small business primarily has cash transactions, has no inventory, and has limited transactions, then the cash basis might be the more straightforward method to adopt. 

But if your small business has growth plans, requires external funding, or if you expect to track inventory in the future, it might be wiser to adopt accrual accounting from the beginning. 

Can I change the accounting method for my business? 

Yes, you can change from cash basis accounting to accrual accounting or go vice versa (if your business isn’t required to use accrual accounting by the IRS. 

To switch your accounting method, complete Form 3115 and submit it to the IRS during the taxable year you want to make the change. The IRS will have to approve the change before you can officially alter how you record your income and expenses. 

Transitioning from one method to another can be tricky, and there could be tax implications, especially if you have limited resources. LZ Books can help you make the switch and offload your bookkeeping so you can focus on more important aspects of your business. 

When does a business account for revenue in cash basis accounting?

With cash basis accounting, a small business owner will only record revenue when the cash is received for a product or service. 

Is cash basis accounting compliant with GAAP?

No, cash basis accounting doesn’t comply with GAAP. Your business has to use the accrual method to be compliant with GAAP.