The difference between cash and accrual
The difference between cash and accrual accounting lies in the timing of when sales and purchases are recorded in your accounts. Cash accounting recognizes revenue and expenses only when money changes hands, but accrual accounting recognizes revenue when it’s earned, and expenses when they’re billed (but not paid).
We’ll look at both methods in detail, and how each one would affect your business.
Cash basis accounting
The cash basis of accounting recognizes revenues when cash is received, and expenses when they are paid. This method does not recognize accounts receivable or accounts payable.
Many small businesses opt to use the cash basis of accounting because it is simple to maintain. It’s easy to determine when a transaction has occurred (the money is in the bank or out of the bank) and there is no need to track receivables or payables.
The cash method is also beneficial in terms of tracking how much cash the business actually has at any given time; you can look at your bank balance and understand the exact resources at your disposal.
Also, since transactions aren’t recorded until the cash is received or paid, the business’s income isn’t taxed until it’s in the bank.
Accrual basis accounting
Accrual accounting is a method of accounting where revenues and expenses are recorded when they are earned, regardless of when the money is actually received or paid. For example, you would record revenue when a project is complete, rather than when you get paid. This method is more commonly used than the cash method.
The upside is that the accrual basis gives a more realistic idea of income and expenses during a period of time, therefore providing a long-term picture of the business that cash accounting can’t provide.
The downside is that accrual accounting doesn’t provide any awareness of cash flow; a business can appear to be very profitable while in reality, it has empty bank accounts. Accrual basis accounting without careful monitoring of cash flow can have potentially devastating consequences.
Diagram comparing accrual and cash accounting
|Cash accounting||Accrual accounting|
|Recognizes revenue when cash has been received||Recognizes revenue when it’s earned (eg. when the project is complete)|
|Recognizes expenses when cash has been spent||Recognizes expenses when they’re billed (eg. when you’ve received an invoice)|
|Taxes are not paid on money that hasn’t been received yet||Taxes paid on money that you’re still owed|
|Mostly used by small businesses and sole proprietors with no inventory||Required for businesses with revenue over $25 million|
The effects of cash and accrual accounting
It’s vital to understand the differences between cash and accrual accounting, but it’s also necessary to put them into context by considering the immediate implications of each technique.
Let’s look at an example of how cash and accrual accounting affect the bottom line differently.
Imagine you perform the following transactions in a month of business:
- Sent out an invoice for $5,000 for a web design project completed this month
- Received a bill for $1,000 in developer fees for work done this month
- Paid $75 in fees for a bill you received last month
- Received $1,000 from a client for a project that was invoiced last month
The effect on cash flow
- Using the cash basis method, the profit for this month would be $925 ($1,000 in income minus $75 in fees).
- Using the accrual method, the profit for this month would be $4,000 ($5,000 in income minus $1,000 in developer fees).
This example displays how the appearance of income stream and cash flow can be affected by the accounting process that is used.
Note: Xorosoft by default supports accrual-based accounting.