The two most common methods of business accounting are cash basis and accrual basis. Companies are generally free to choose which method best fits their business, but many small businesses start out using cash basis because it can be easier. However, there are pros and cons for both methods. The primary difference between them is the timing of when transactions are recorded.
What Is Cash Basis Accounting?
The cash basis of accounting records business transactions when cash changes hands. In other words, revenue is recorded in the actual period when a business receives cash, and expenses are reflected when cash is paid out. Further, cash basis accounting focuses only on cash transactions, thus sidestepping issues like accruals, deferrals, and non-cash items, such as depreciation (all hallmarks of the accrual basis of accounting).
“Cash basis accounting captures transactions when there is cash involved,” explains Lisa Koonce, an accounting professor at the University of Texas at Austin. “For example, when buying office supplies, the company typically pays cash for them. Under cash basis accounting, the company then has a business expense and a reduction in their cash balance.”
Cash basis is the simpler of the two accounting methods, and can give business managers a good view into cash flow, but it does not comply with U.S. Generally Accepted Accounting Principles (GAAP), a stipulation typically required by third-party investors and lenders.
Examples Using the Cash Basis Method
To illustrate how cash basis accounting works, consider these hypothetical transactions:
- Revenue: A cash-basis business makes a sale and delivers the pertinent goods or services in March, offering their customer 30-day payment terms. If the customer pays immediately, the revenue would be recorded in March. But if the customer takes the full 30 days to pay their invoice, the business would record the revenue in April, when the payment actually arrives.
- Expenses: A business pays its employees every Friday for the pay period ended the prior week. This cash-basis business would record the expense of paying workers on payday, when paychecks are actually distributed, rather than when the workers earned the pay. Therefore, the payroll expenses reflected in the financial statements would always be on a one-week lag.
- Asset purchases: A business buys a new delivery truck that it expects to use for the next five years. If paid in full, the entire cost of the truck would be reflected as an expense upon purchase.
- Unlike accrual accounting, the cash basis of accounting reflects business transactions occurring in a particular financial period at the time cash is received or disbursed.
What Is Accrual Accounting?
Accrual accounting is the GAAP-compliant alternative to cash basis accounting. “In contrast [to cash basis], accrual basis accounting captures transactions when an economic event occurs, which may or may not involve cash,” Koonce says. “So, for example, when a company uses electricity, they would, under accrual accounting, recognize electricity expense at that time. They would do so even if the payment for that month’s electricity bill occurs later on, like the next month once the bill arrives.”
The accrual method follows two accounting principles: the revenue recognition principle and the matching principle. The revenue recognition principle states that revenue is recognized when it’s earned, regardless of when cash is received. If we recast the cash-basis example shown above as an accrual accounting transaction, the revenue from the March sale now would be reflected in the month of March, when the seller’s obligations are fulfilled, even though no cash has been collected. Similarly, a consultant would record billable hours as revenue as soon as they are completed, a building contractor would record revenue when a remodeling job is finished, and a manufacturer would record revenue when product has shipped.
Under the matching principle of accrual accounting, expenses would be reflected in the period that best matches the revenue they help create, rather than simply when the cash is paid. When it comes to payroll, each pay period’s expenses would be accrued during the period in which they were incurred – so, you’d record the costs of paying workers as they do the work, rather than when paychecks are distributed.
Because accrual accounting records revenue when earned and expenses when incurred, rather than following cash inflows and outflows, it can give a more accurate overall picture of a business’s operations.
Advantages of Cash Basis Accounting
The primary advantage of cash basis accounting is its simplicity. Much like the familiar exercise of maintaining a checkbook, bookkeeping under the cash basis simply follows the cash flows in and out of a business. As a result, it can reduce bookkeeping costs.
In addition, financial statements prepared using the cash basis of accounting more closely reflect a business’s cash position – a major concern for many small-business owners. Tracking cash flow can, therefore, be a bit more straightforward and less complicated than it is with accrual accounting.
Disadvantages of Cash Basis Accounting
Although it’s simpler than accrual accounting, cash basis accounting does have some limitations. These limitations prompt many businesses eventually to switch over to accrual accounting as their finances become more complex.
“The biggest disadvantage of cash basis accounting is that it doesn’t capture economic transactions in the right time period,” Koonce notes. Significant swings in cash can distort the financial results, obscuring the true nature of a business and complicating planning and forecasting.
Another key disadvantage is that cash-basis financial statements are not GAAP-compliant, a common requirement of third parties, such as lenders, investors, or private equity buyers. In addition, public companies must be GAAP-compliant and, therefore, must always use accrual-based accounting.
Furthermore, a company that uses the cash basis of accounting may need to put additional procedures and controls in place that can erode the method’s overall ease of use. For example, the company may need to create a supplemental process to stay on top of outstanding amounts due from customers, since it won’t have accounts receivable ledgers. Or, it may need to establish additional controls to handle cash receipts and disbursements, to limit the likelihood of loss or theft.
Which to Use? Cash vs. Accrual Basis Accounting
For some businesses, the choice is straightforward, while others can choose which best fits their operations. If a business is publicly traded, they must be GAAP-compliant, as must most businesses with external investors or lenders. For these companies, cash basis accounting is not an option, so they must use accrual basis of accounting for both financial reporting purposes.
If accrual accounting is not required by some third party, companies are free to select either method. Some use a combination of the two, employing the accrual method for sales and purchases of inventory and cash for other income and expenses.
A business’s size – as well as its industry and goals – can also play a role in deciding which to use. Larger companies that undertake serious, long-term planning are more likely to build their strategic plans and budgets using the accrual accounting method, since it can eliminate the distortive swings typical of cash basis. “Accrual accounting is often more useful for long-term planning,” says James Cassel, chairman and co-founder of Miami-based investment banking firm Cassel Salpeter.
On the other hand, “cash basis accounting adequately reflects many small firms’ financial situations,” says Cassel. Restaurants, for instance, are often well suited to cash accounting because there’s little difference in the timing of when they receive money and when they pay bills. “With most restaurants, if they’re paying bills on time, everything is within 30 days. They’re getting paid when the customer comes in, with cash or credit card, then receiving the credit card payments in a couple of days,” Cassel says. “It doesn’t make a lot of difference in how they manage the business whether they use cash or accrual.”
Despite its limitations, the cash basis may be right for your business. It’s popular among smaller businesses, especially those that rely entirely on cash payments, both for revenue and for expenses, and that don’t carry inventory. The shorter the lag in converting sales to cash, the more likely cash-based accounting could make sense. Conversely, organizations that rely on credit, either by extending it to customers or using it with their suppliers, and hold large amounts of inventory will likely find that accrual accounting gives a more accurate financial picture.
The Bottom Line
Unlike accrual accounting, the cash basis of accounting reflects business transactions occurring in a particular financial period at the time cash is received or disbursed. It’s the simpler of the two primary accounting methods, which is one reason it can be preferred for many small businesses and entrepreneurs. However, it’s important to understand its limitations, especially to avert growing pains if and when the time comes to transition to GAAP-compliant financial accounting, which uses the accrual basis.
A version of this article was originally published on April 08, 2020.
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