Cash vs Accrual Accounting

Cash Basis vs Accrual Basis Accounting: A Comprehensive Guide

One of the most fundamental questions business owners face is whether to use cash basis or accrual basis accounting. The choice impacts everything from tax planning to financial reporting and cash flow management.

In this in-depth guide, we’ll demystify the key differences between cash and accrual accounting across reporting, taxes, workflows and more. We’ll also offer guidance on when each method makes sense based on your business model and stage of growth.

Let’s dive in.

Defining Cash Basis Accounting

Cash basis accounting recognizes income and expenses based on real-time cash flows – i.e. when cash is actually exchanged.

With cash accounting:

• Revenue is recorded when payment is received from customers
• Expenses are recorded when bills are paid

Cash accounting is guided by real-time cash transactions, ignoring accounts receivable and accounts payable. It provides an immediate picture of liquidity and cash available.

Cash basis is commonly used by:

• Startups
• Small businesses
• Freelancers
• Contractors
• Sole proprietors

The simplicity and liquidity focus of cash accounting appeals to many small entities. However, accrual accounting often provides more financial clarity as companies scale.

The Benefits of Cash Accounting

Cash basis offers a few advantages:

• Simplicity– Easy to track income and expenses based on bank transactions.
• Liquidity– Shows real-time cash available rather than outstanding invoices or bills.
• Minimal bookkeeping– Reduces time on receivables, payables and deferrals.
• Tax deferment– Delays tax payments until cash is received.

For small businesses, cash basis requires less oversight and administrative work than accrual accounting. It provides an instant snapshot of cash balances free from outstanding obligations.

The Drawbacks of Cash Accounting

However, cash basis also comes with downsides:

• Income timing distortions– Revenue lags collection, misrepresenting earnings.
• Expense timing distortions– Expenses may hit books much later than consumed.
• No matching principle– Revenues and expenses misalign with reality.
• Limited financial reporting– Financial statements don’t reflect business activity accurately.
• Tax planning challenges– Spikes in collections can disproportionately increase tax burden.

The mismatch between income/expense timing and reality can provide a misleading picture of profitability and hinder reporting.

Defining Accrual Basis Accounting

In contrast to cash basis, accrual accounting aims to match revenues and expenses to actual business activity over time. This provides a more accurate picture of financial performance.

With accrual accounting:

• Revenue is recorded when sales occur or services are delivered
• Expenses are recorded when they are incurred

Accruals track outstanding accounts receivable and accounts payable. Common examples:

• Recording sales when a project finishes, not when paid
• Recording expenses when supplies are consumed, not when invoiced

Who uses accrual accounting?

• Public companies
• Partnerships
• Nonprofits
• Larger corporations
• Businesses selling merchandise

Accruals are required for any business with over $25 million in annual revenues. But smaller businesses often use accruals by choice for financial clarity.

The Benefits of Accrual Accounting

Key upsides to accrual basis:

• Revenue timing– Recognizes revenue accurately as earned over time.
• Expense timing– Matches expenses to usage rather than varying cash outlay.
• Matching principle– Aligns revenue and expenses appropriately.
• Financial reporting– Provides realistic data for financial statements.
• Performance metrics– Enables accurate profitability metrics and ratios.
• Operational insights– Shows impact of credit policies and payment lags.

Accruals provide financial intelligence not apparent from cash flows alone. This informs strategic decisions and valuation.

The Drawbacks of Accrual Accounting

Accrual accounting isn’t without its downsides:

• Complexity– More labor intensive bookkeeping managing accruals and deferrals.
• Cash flow uncertainty– Doesn’t reflect real-time cash position.
• Tax planning challenges– Requires forecasting tax obligations from accrual-based income.
• Higher accounting costs– Typically requires professional accountants.

Accrual accounting creates additional accounting work. Business owners also lose instant cash flow visibility requiring cash flow planning discipline.

Key Differences Between Cash and Accrual Accounting

While both methods aim to record financial transactions, the key divergences include:

• Income timing– Cash recognizes income at collection vs accrual at delivery.
• Expense timing– Cash recognizes expenses at payment vs accrual at consumption.
• Receivables/payables– Cash ignores AR and AP, accruals track them.
• Financial reporting– Accruals better match revenues and expenses.
• Tax timing– Cash defers tax until collected, accruals account for obligations.
• Accuracy– Accruals capture business activity more precisely.
• Ease of use– Cash basis is simpler, accruals require more oversight.

Bottom line – cash basis provides liquidity visibility, while accruals prioritize financial accuracy.

How Cash and Accrual Accounting Impact Taxes

Tax treatment also differs under cash and accrual models:

• Cash basis– Taxes paid on income when received and expenses when paid. This allows tax deferment until cash is collected.
• Accrual basis– Tax obligations accounted for when income is earned and expenses incurred regardless of cash flow timing. Requires tax planning for accrued liabilities.

This can create major tax timing differences. Accrual accounting provides smoother income statement recognition but creates complexity estimating future tax liabilities.

Which Accounting Method Is Right For Your Business?

When choosing an accounting method, key factors to consider:

• Business model– Accruals suit product companies, cash fits projects.
• Inventory– Any inventory necessitates accrual accounting.
• Revenue– Over $25M in revenue requires accrual basis.
• Growth stage– Growing businesses benefit from accrual insights.
• Tax strategy– Weigh tax deferment under cash vs accrual planning.
• Accounting needs– Accruals require more time and potential accountants.
• Reporting needs– Accruals offer greater financial statement accuracy.

Evaluate your operations, systems capabilities, tax policies and reporting requirements. For many large and mid-sized businesses, accrual accounting provides the most accurate financial picture at the cost of added complexity.

Making the Switch

If you determine it’s time to switch methods, you need formal approval from tax authorities to change accounting methods. This involves filing documentation explaining the business reasons for the change.

With the right strategic justification, most requests are approved. Software also increasingly allows seamless accounting method toggling.

The Power of Real-Time Switching

Rather than choosing a single accounting method, leading solutions like Fiskl enable real-time switching between cash and accrual views for comprehensive financial management.

With a click, Fiskl customers can toggle between:

• Accrual Basis – View income statement, balance sheet and fully matched financials.
• Cash Basis – See real-time cash position and liquidity.

This provides complete financial intelligence in one integrated ledger. Fiskl’s automated accrual engine also manages hassles like:

• Multi-currency accruals
• Deferred revenue tracking
• Account reconciliations
• Aged payables and receivables

The result is single source of truth financials fully tailored to your business needs.