What is the Difference Between Cash and Accrual Accounting?
You've probably heard of these two terms when researching small business bookkeeping... accrual-basis and cash-basis.
All business owners must decide when starting their company whether they want to use the cash method or the accrual method for reporting their financials. I am here to give you the breakdown of what the difference is between the two (and probably try to sway you in the direction of accrual if I can).
CASH BASIS BOOKKEEPING
The simplest method. Best for very small businesses with straight-forward sales or personal bookkeeping. Not ideal for analyzing income and expenses month to month.
The cash accounting method essentially records income as it is deposited into your bank account, and records an expense as it is withdrawn from your bank account. There is no A/R or A/P when using this method, everything is based off of cash-in and cash-out and recorded immediately.
This can be a major drawback when you want to review your monthly P&L report since it will not be a TRUE representation of what you make or spend in a month. This is because you might get paid for a job in May, but not actually do the work until June. On a cash-basis system the income will be shown as May income.
Although most businesses are required by law to use an accrual system, some small businesses may be able to utilize a cash system if their sales are less than $5 million a year. It's smart to always check with your accountant if you are one of the small businesses who qualify for cash-basis since switching from cash to accrual can be quite the task.
ACCRUAL BASIS BOOKKEEPING
More involved method. Best for businesses who want to analyze their financial data and profitability. Most businesses use this method.
The accrual accounting method records income and expenses as they occur, not when cash is moved. Simply put - this means that if you get paid for a sale in May, but do not deliver the product until June, you do not get to claim the income until June. This is because no transaction occurred during May - only cash was deposited.
Note that it's important to ALSO manage cash flow at the same time while using the accrual method because it does not accurately represent how much money is actually in your bank account at any given time. We can see this in the example above.
Accrual gives you better insight for budgeting and analyzing. Lenders are more willing to let you borrow because you show consistent income. It will also let you see the best times of the year to do marketing campaigns based on previously trending high sales months/seasons. In addition, your business can accrue expenses over time instead of taking one big hit.
At the end of the day, it really is dependent on your specific business and business plan. There are advantages and disadvantages to both (however, I would argue that knowing your profitability is a HUGE advantage!).