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As a small business owner, you’re going to have many choices and decisions to make. Some will have more obvious answers while others may require some research and thought. Knowing the difference between cash basis vs. accrual basis method of accounting will be an important understanding in order to position your company for future success.

Each method has different effects on cash flow and your bottom line. The key difference between these two accounting methods is the point at which you record revenue and expenses in your book. That being said, you should spend some time determining what type of accounting method to implement for your small business.  This, of course, depends on the nature of your business and how you want to account for items on your financial statements. Small service businesses may use the cash basis because they have few receivable and payables. For them the cash basis financial statements would provide the information they need analyze their business performance. For more large businesses, however, the cash basis will not provide the most accurate information for their financial statements analysis.

Cash Basis Accounting

The cash basis method of accounting is based on when the exchange of cash takes place. So, you will recognize revenue when the cash is received and record an expense when a bill or invoice is paid. Therefore, there isn’t a need for accounts receivable or accounts payable when using the cash basis method. Since no transactions are recorded on the books unless you spend or receive money, this is the simplest method to utilize when accounting for the activity that takes place within your small business.

This method of accounting is commonly used by small businesses primarily because it is relatively simple to keep up with and maintain.

Missing the matching principle

The ease of using the cash method is more than offset by the fact that the method fails to match revenue to the expenses your company incurs to earn that revenue. Because the matching principle isn’t applied, cash basis financial statements usually don’t present as accurate a picture of how the business is performing as accrual method financial statements do.

Consider an example. Lets say ABC Corp. has revenue of $40,000 and expenses totaling $15,000 associated with that revenue in April. $20,000 of the revenue was received in cash and the rest is on account. ABC Corp. paid cash for the entire $15,000 of expense. Using the cash method, ABC Corp’s net income for April is $5,000 ($20,000 cash revenue – $15,000 cash expenses). But, that $5,000 of net income grossly under-represents the volume of activity the company had during the month. The figures could be just as wildly inaccurate if the company didn’t pay any of its expenses and had cash sales of $30,000–or for any other scenario involving the use of cash changing hands as a criteria for recording net income.

Accrual Basis Accounting

Using an accrual based accounting method rather than vs. cash basis accounting doesn’t change how your financials look but rather how you will interpret them. The key differences are not IF you record the business transaction but rather WHEN.

Under this method, you record revenue when it’s earned and realizable, and you record expenses when thy’re incurred — regardless of whether or when money changes hands. Wondering what the criteria are for revenue to be earned and realizable? The earned criterion is satisfied when the vendor satisfactorily performs on its contract with the customer.

Typically revenue is considered earned when the vendor delivers the goods or services. Realizable means that the company has good reason to believe it will receive payment; for example, the customer swipes his/her debit card and enters his/her PIN.

One benefit of accrual basis method of accounting is that it allows for a better analysis of your business’ financials. It considers transactions as well as events which results in a more accurate financial picture of the business reflecting the true position. You can set more long-term financial goals since you have a better grasp on your income earned and expenses incurred over a period of time.  

A downside to the accrual basis accounting is that it doesn’t show you true cash flow. It may look like your profits are increasing when in actuality your bank account is nearly overdrawn. Because of this, it is critical that a business using the accrual method constantly monitor cash flow in order to ensure that monthly obligations can be met.

Cash Flow Effects

It is important to understand how both the cash basis vs. accrual basis methods of accounting can effect the business’ financials. To understand the direct effect on the bottom line, let’s consider the following example:

In the month of July, you invoice a client for $3,000 of consulting work, the client pays you $1,000 in cash towards that invoice and you pay $100 towards the May’s Supplier bill.

Now, let’s pretend these were the only three transactions that took place in the month.

Under the cash basis of accounting, your Income Statement would show a profit of $900 for the month. Only the exchange of cash is recorded on the books.

July Income Statement (Cash Basis)
Revenue $1,000 (actually received)
Expenses -$100 (actually spent)
Profit        $900

Under the accrual basis accounting, your Income Statement would show a profit of $3,000 for the month. Only the invoice sent to the client in July would be recorded as income. The May supplier invoice was recorded on the May Income Statement.

July Income Statement (Accrual Basis)
Revenue $3,000 (when earned)
Expenses $0  (when incurred)
Profit $3,000

Both of these methods are important in their respective areas. That means you need to know and understand which accounting method is applicable.  Be sure to consider your business model and how you operate when determining which method of accounting you feel is best for your small business.

Post Author: Lorrie Toillion, CFP®

Accounting Specialist, Tax Assistant, and Client On-Boarding Associate.