Choosing between accrual or cash basis accounting depends on the size of your business and whether you need to present your financial information to shareholders. It also depends on your sales revenue and whether you’re a publicly traded company.
In this blog, we’re looking at the differences between accrual and cash basis accounting and which one you should use depending on your company’s current financial situation.
At Fully Accountable, we’re committed to providing you with the accounting method that makes the most sense for your business. That’s why our full-service accounting team offers fractional digital accounting services that simplify compliance and create larger financial strategies.
Continue reading to learn more about the differences between cash basis and accrual accounting.
An Overview of Accrual Vs. Cash Accounting
The fundamental difference between accrual and cash accounting is the timeframe of the revenue and expenses. Cash method accounting immediately recognizes revenue and expenses while accrual focuses on anticipated revenue and expenses.
Accrual then, records revenue and expenses when cash related to these transactions is received or dispensed. This provides a more accurate view of a company’s financial health by including accounts payable and receivable.
The accrual method is the more commonly used method among larger companies, especially publicly-traded companies because it provides a more comprehensive overview of earnings over time. Cash basis accounting is primarily used by smaller businesses.
What Does It Mean to Record Transactions?
Recording transactions refers to the point at which you record incoming revenue. By law, every business has to record all its financial transactions. If you want to claim tax deductions at the end of the year, you’ll need a central location to add all your income and expenses. Recording transactions refers to when you decide to do this process.
What Is Accrual Accounting?
Accrual accounting includes revenue once earned. This differs from the cash method because accrual records revenue when a product or service gets delivered to a customer with the expectation that money will be paid in the future. Revenue is then counted before it is formally received. The money for goods and services is also recorded before any cash gets paid out.
What Is Cash Basis Accounting?
Cash basis accounting only reports revenue on the income once cash is received and expenses are only recorded when cash gets paid out. Cash method accounting is typically reserved for small businesses and personal finances.
What Are the Differences Between Accrual Accounting and the Cash Method?
The accrual method of accounting records all accounts payable and receivable, which paints a much clearer picture of the profitability and stability of a company, especially in the long term. Under the cash method, a company would likely have solidified sales that wouldn’t be recorded until the following quarter. Investors might mistakenly consider the company unprofitable when the company’s doing well.
The drawback of the accrual method is that it doesn’t account for cash flow. Because it records finances over a longer period of time, it might not display cash flow shortages in the short term. It can also be more complex since it accounts for elements, such as unearned revenue and prepaid expenses.
Accrual method accounting is accepted under the generally accepted accounting principles from the Financial Accounting Standards Boards and it is typically reserved for companies that file audited financial statements.
Cash Basis Method
Cash basis accounting features the advantage of simplicity and it only accounts for the cash paid or received. Sole proprietorships and small businesses typically use this method because it displays cash flow health, which is especially important when you’re beginning. Showcasing longer-term financial health is more important as you grow.
However, cash basis accounting might over-exaggerate a company’s financial health when it’s cash flow is positive. It doesn’t account for the natural financial fluctuations that occur over time. This is because it doesn’t record the company’s cash flow on the books outside of its current revenue stream.
As a result, investors can evaluate the company as profitable when it’s simply cash flow positive for that given period. Unlike the accrual method, the cash basis accounting method is not acceptable under the GAAP. However, as of 2018, small businesses with annual gross receipts of $25 million or less in the prior three-year period can use it.
The accrual method is used more prevalently among publicly-traded companies. One reason for the popularity among publicly-traded companies is that this method smooths earnings out over time while cash basis accounting records more immediately.
For example, if a retail business used the cash basis accounting method, it might look abnormally profitable during quarter four and abnormally unprofitable in quarter one. Both methods have advantages, and it is up to your company to decide which method suits your company best. Investors must understand how both methods impact investment decisions.
How to Choose the Right Accounting Method for Your Business
For small companies that conduct business primarily through cash transactions and who do not maintain large inventories of products, cash basis accounting often makes more sense. This method offers a more convenient way to keep tabs on revenue and expenses without an abnormal amount of bookkeeping.
While ease accompanies the cash basis accounting method, you receive a more an accurate picture of your finances with accrual accounting. Here are some factors you will want to consider while deciding whether cash basis or accrual accounting is the right decision for your business:
The Complexity of Your Business
Depending on your business, one accounting method will be more sustainable than the other. Businesses with multiple accounts, hundreds of employees, and multiple LLCs should stay away from cash basis accounting because they need to present the big-picture view to potential investors.
Another reason you should choose one accounting method over another is your sales revenue. According to GAAP, any business that exceeds $25 million in annual revenue should use the accrual accounting method.
Owning a publicly-traded company or one on the verge of going public might also affect GAAP guidelines. Publicly-traded companies must report accurate views of their financial well-being to shareholders. The best method for this is the accrual system of accounting.
Hybrid Methods of Accounting
Some small businesses use a hybrid accounting system. They might base large financial decisions on loan applications and accrual accounting but utilize cash basis accounting to simplify their tax accounting. A substantial number of rules govern which businesses can implement hybrid accounting, so you should speak to an accountant or tax professional before implementing this into your business.
Bottom Line- Should I Use Accrual or Cash Basis Accounting?
Deciding whether you should use cash basis or accrual accounting for your business depends on the size of your company and when you would like to record transactions. As we’ve discussed, accrual accounting gives you a more complete picture of your business’s financial health over time. Cash basis gives you a shorter window into your financial health but can reveal short-term cash flow dynamics.
If you struggle with deciding which would fit your organization best, contact the professionals at Fully Accountable. Our accounting firm prides itself on implementing the correct procedures at your company to improve your bottom line and ensure you accomplish sustainable expansion over time.