Accrual vs. Cash Basis Accounting: The Pros and Cons of Each and Which One is Best for my Company?
- smini18
- Sep 7, 2024
- 5 min read
I’m sure you’ve heard these terms before from your accountant, banks, associates, and others within the business community. It’s those dreaded accounting terms that creep up from time to time in your conversations, only to wreak more chaos and confusion in your mind: Accrual vs. Cash Basis!!! But what exactly do these terms mean?!?
When running a business, it can be difficult keeping up with all the different terms that get thrown out there when it comes to your finances, and at times, it can become overwhelming! So how can you truly understand the difference between these two accounting methods and which one is best for you and your business?!?
Well, have no fear! In this post, we will delve into the definition of each accounting method, the pros and cons for each, and which one might be best for you and your business.
So what exactly are the definitions for accrual and cash basis accounting?
Accrual Accounting: Money is accounted for in the financial books before it is received or paid out.
Cash Basis Accounting: Money is only accounted for in the financial books when it is actually received or paid out.
Now that we know the basic definitions of each type of accounting method, let’s delve in deeper to learn more about each of these methods and what might work best for you and your business.,
Accrual Accounting
Like mentioned above, in accrual accounting, revenue and expenses are accounted for in the financial books with the expectation that the money for these transactions will be collected at a later date. This is usually accomplished through two accounts that make up an accrual financial system: Accounts Receivable and Accounts Payable.
Accounts Receivable is an account that holds transactions for expected money coming into a business from services or products sold.
Accounts Payable is an account that holds bills and outgoing money that the business owner will eventually pay to help run their company.
Even though the money may not “physically” be in or out of the bank account yet, the accrual method gives the business owner a more complete and accurate look at the profitability of the company in the long term. You can kind of think of accounts receivable and accounts payable like "placeholders": The transactions have been accounted for in the books, but now you are just waiting for the money part of the transaction to take place, then it will be complete! For example, a company may make a group of sales in one quarter, but not receive payment for them until the next quarter. In a cash basis accounting method, this could present itself as no profit for that quarter, but with the accrual accounting method, end of quarter reports will show that the company is indeed making a profit, even though the money for these sales are not expected until a later date.
Who can benefit from using the Accrual Accounting method?
The accrual accounting method is the more commonly used accounting method amongst businesses because it gives a more accurate picture of profitability in the company over time. If your company needs an accounting system to manage multiple financial moving parts within the company, then the accrual accounting method may be for you. Other benefits from using the accrual accounting method include:
Ability to accurately track credit card, invoice, and bill payments: Credit card and invoice transactions in the sales of services and products can take time to post, so using accounts receivable in accrual accounting can help give a more accurate picture of business income and profitability. Likewise, when a bill comes in that needs to be paid, the bill can be accounted for in the books under accounts payable until the money goes out to pay for it.
Tracking assets and liabilities: Businesses can have a wide range of different types of assets and liabilities, and accrual accounting helps distinguish and track all the different types so owners can keep tabs on them.
GAAP Compliance: GAAP stands for Generally Accepted Accounting Principles and these principles are required for all public companies in the United States. Therefore, to remain in compliance, public companies are required to utilize accrual accounting practices for accurate financial records.
What are some of the downsides to using the Accrual Accounting Method?
It can be complex and complicated to use: The accrual accounting method can be confusing to use, since it requires the accounting of transactions like unearned revenue and prepaid expenses.
It does not track cash flow: Unlike cash basis accounting, accrual does not track cash flow, and although a company may look profitable in the long term, they may have a major shortage of cash flow in the short term.
Cash Basis Accounting
The #1 advantage of cash basis accounting is its simplicity: It basically is an accounting method that accounts for cash paid and cash received. When cash is received by the business for the sale of a service or product, it is then, and only then, recorded in the books. Likewise, business expenses are only recorded in the books when cash is paid out and leaves the business. Unlike accrual accounting, this accounting method also makes it easier for business owners to track cash flow.
Who can benefit from using the Cash Basis Accounting Method?
Cash Basis Accounting can be beneficial for sole proprietors and small businesses. Other reasons why business owners opt for cash basis include:
The business does not have an inventory: Companies need to account for their inventory at the beginning and end of the tax year (which Accrual Accounting allows business owners to accomplish), but if a company does not have an inventory associated with the business, then cash basis accounting can work well for the owner.
The business only uses cash for transactions: Cash-only business are not as common as they once were, but if a company only works with cash transactions, then monitoring cash flow with cash basis accounting is a viable option.
What are some of the downsides to using the Cash Basis Accounting Method?
Although cash basis works well with many sole proprietors and small businesses, there are definitely some business and financial disadvantages. If a business solely focuses on cash flow as an indicator of business profitability and financial reports show that the company is “cash-rich”, this can be a misleading indicator of how well the company is doing and does not paint an accurate financial picture of the company.
For example, the amount of business profitability when monitoring cash flow can be substantially diminished if there are unpaid business bill amounts that exceed the amount of cash being generated in the company’s incoming revenue. In this case, although the financials show a cash-rich business, the actual amount is actually much lower because of the larger amounts associated with the business' unpaid bills.
If there is concern about the financial well-being of the company and other details apart from cash-flow, cash basis is not a good accounting option.Some other considerations with using Cash Basis include the following:
Assets and Liabilities may not be represented accurately in the financial books: Cash basis accounting can leave out pertinent information from the books on unpaid invoices, company liabilities, and important business assets.
Cash Basis Accounting is not GAAP compliant: Public companies need to follow strict financial guidelines set forth in the GAAP. Cash basis accounting is not an accepted accounting method per these guidelines.
The Bottom Line
In the end, both accrual and cash basis accounting methods have their advantages and disadvantages, but now that you are armed with a bit more information, you have the power to make an informed decision about which method will work best financially for you and your business.
And maybe, by choosing an accounting method that will work well in determining your business' financial health, you'll even have some extra money for some special treats at the end of the month!!!
As always, if you still have questions or need help with your bookkeeping records, you can always reach out to us at Owl Eye Bookkeeping Services at susan@owleyebookkeeping.com
Interested in learning more about my bookkeeping services for your small business? Reach out and say "Hi" by checking out my webpage at
Happy Bookkeeping!