The two differ in the timing of when revenue and expenses are reflected in your accounts. Cash accounting recognizes expenses and revenue when the funds change hands, while accrual accounting recognizes them when they are incurred. The cash method of accounting is generally suitable for very small businesses without any inventory. The accrual method is more popular and conforms to the generally accepted accounting principles (GAAP). Learn more about how cash accounting and accrual accounting work and which method may be best for you.
What’s the Difference Between Cash Accounting and Accrual Accounting?
When someone files a business’s first tax return, they choose which accounting method they want to use. The following table shows, at a glance, the key differences between cash and accrual accounting:
Accuracy
Accrual accounting is generally considered to provide a more accurate long-term picture of the firm’s financial health. With this method, companies look at both current and expected cash flow projections, while cash accounting does not recognize unpaid bills that are coming. Accrual accounting is effective in smoothing out revenue over time. The downside of accrual accounting is the fact that it is associated with the risk of bad debt because the revenues are not collected yet even though they are incurred and invoiced. Moreover, the advantage of smoothening revenues can turn into opportunities for accounting shenanigans if it is practiced in excess.
Complexity
Cash accounting is simple for a small business, as it’s just like taking care of your checkbook. Accrual accounting is more complex since you have to keep track of more accounts.
Which Is Best for Your Business?
Cash accounting is used by many small businesses because of its simplicity. Income and expenses are recorded in your books only when the cash hits your account or leaves it. Small-business taxpayers with average annual gross receipts of $25 million or less in the prior three-year period can use the cash method of accounting. The cash method is best for small service businesses with low inventory, while the accrual method of accounting is best for large businesses with complex practices. Businesses with average annual gross receipts of more than $25 million for the prior three years must use the accrual accounting method. This method tends to offer a more accurate long-term view of your business finances, which allows you to see what income and expenses you have yet to earn or pay.
A Best-of-Both Worlds Option
At times, it makes sense for businesses to use both cash and accrual accounting. This is called the hybrid method of accounting. The hybrid accounting method makes it possible to track cash flow and get a long-term view of the firm’s financial health. However, according to the IRS, you must follow a few restrictions when using the hybrid method:
When inventory is necessary to account for your income, a business must use the accrual method for purchases and sales. If a business uses the cash method to report income, it must also use the cash method to report expenses. If you use the accrual method for reporting expenses, you must also use the accrual method for figuring out income. Any combination of reporting that includes the cash method is treated as the cash method, according to the Internal Revenue Code.
The Bottom Line
Cash and accrual accounting are accounting methods appropriate for different companies, industries, and situations. Cash accounting recognizes revenue and expenses when money changes hands. Accrual accounting recognizes revenue and expenses when they are incurred. The hybrid method uses elements of both. To choose your method of accounting, you must compare your business situation to the rules for accounting stated by the IRS.
