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Cash vs Accrual

Which Method is Better?

The difference between the two is timing; the time at which the transaction is recorded.

When first starting your business, it’s important for you to understand the basics of the two principal methods of keeping track of a business’s income and expenses: cash method and accrual method (also called cash basis and accrual basis). In short, these methods differ only in the timing of when sales and purchases are credited or debited to your accounts.

Cash Accounting – Record transactions when the invoice or bill is paid, as opposed to when the invoice or bill is created.

Pros for Cash:

  1. Easy – no need to track accounts payable or receivable. If it’s paid, it’s in the system.
  2. If you invoice in a different system, no sweat. Just record the receipt of cash as revenue.
  3. Can easily track cash flow. If revenues are high on the Profit & Loss statement, the cash will be high

Cons for Cash:

  1. Will not have as accurate of a picture of the profits earned after the expenses that are associated with the same materials / services.
  2. Does not follow Generally Accepted Accounting Principles (GAAP), which implements the matching principle, matching expenses with associated revenue.

TIP: Pay all of your bills before the end of the year, so that you can take full advantage of your deductible expenses.

Gain valuable insight when all your fish (transactions) swim together

Accrual Accounting – Record transactions when revenues and expenses are earned, whether money has changed hands or not.

Pros for Accural:

  1. Implements the GAAP guidelines’ matching principal, where revenues and expenses are recorded/matched within the same time period, so business owners/partners are more accurately informed about their profits after expenses

Cons for Accural:

  1. Must carefully track cash flow, or include the Statement of Cash Flows report in regular reporting to know your cash on hand. The accrual method can make the Profit & Loss statement to show high revenues while cash is low.

Illustration:

An owner pays $1000 in March for product that’s sold/invoiced at the end of March for $1600, but paid by the customer when received, in the beginning of April.

Cash Method
Profit/Loss March April
Income $0 $1,600
Expenses $1,000 $0
Net profit -$1,000 $1,600
Accrual Method
March April
$1,600 $0
$1,000 $0
$600 $0

Most businesses that have sales of less than $5 million per year are free to choose which accounting method to adopt. But if your business stocks an inventory of items that you will sell to the public, the IRS requires you to use the accrual accounting method. Inventory includes any merchandise you sell as well as supplies that will physically become part of an item intended for sale.

In summary, Whichever method you use, it’s important to realize that either one gives you only a partial picture of the financial status of your business. While the accrual method shows the ebb and flow of business income and debts more accurately, it may leave you in the dark as to what cash reserves are available, which could result in a serious cash flow problem.

Although the cash method will give you a truer idea of how much actual cash your business has, it may offer a misleading picture of longer-term profitability. Under the cash method, for instance, your books may show one month to be spectacularly profitable, when actually sales have been slow and, by coincidence, a lot of credit customers paid their bills in that month. To have a firm and true understanding of your business’s finances, you need more than just a collection of monthly totals; you need to understand what your numbers mean and how to use them to answer specific financial questions.

karen todd

Article by Karen Todd,
Senior Financial Analyst ~ Accredited Business Advisor
Profit Source Advanced Bookkeeping