Cash vs. Accrual Accounting for Bookkeeping – Which One Should You Choose?
When running a business, picking your method of accounting is a decision that will impact everything you do after. It’s important you think about it carefully!
In this article, we examine the difference between cash and accrual accounting. We’ll discuss the key features, pros, and cons of each, from a bookkeeping perspective.
Let’s get started.
What Is Cash Accounting?
Cash accounting, also known as cash-basis accounting, is a method of bookkeeping where revenues and expenses are recognized only when cash is received or paid out.
In the case of cash accounting, we record financial transactions based on when the cash actually flows in and out of the business.
Revenue is recorded when payment is received from customers, regardless of when goods or services were provided. Expenses are recorded when they are paid, regardless of when they were incurred.
This method focuses solely on cash transactions, providing a clear picture of the immediate cash position of a business.
While cash accounting provides a clear picture of immediate cash flow, it lacks when it comes to understanding a company's unit economics. Cash accounting may not accurately reflect the relationship between costs incurred and revenue generated, because there can be a big time gap between when money is spent on production, and received for sales.
Pros
Simple – It's easy to understand and implement, making it popular for small businesses and sole proprietors.
Immediate visibility – It provides a clear view of how much money the business actually has on hand.
Cons
Not always accurate – It may not provide a complete picture of a company's financial health, especially in the short term, as it doesn't account for outstanding receivables or payables.
Potential misrepresentation – It can overstate or understate a business's condition if collections or payments are particularly high or low in a given period.
Incomplete cost picture – Cash accounting might not capture all costs associated with producing a unit of product or service, especially if some expenses are paid in a different period than when the revenue is received.
What Is Accrual Accounting?
Accrual accounting is a method of bookkeeping that recognizes revenue and expenses when they are earned or incurred, regardless of when the actual cash changes hands.
Revenue is recorded when it's earned, and expenses are recorded when they're incurred, not when cash is received or paid. That means it’s recognized when earned or incurred once the service is being / has been delivered or received.
Accrual accounting follows the matching principle, which states that revenues and expenses should be recorded in the same accounting period. This helps us better understand the unit economics of a business.
Pros
More accurate financial reporting – It gives a more clear view of long-term profitability and financial performance.
Better for business operations – It reflects the economic reality of business transactions more accurately.
Better for unit economics – It aligns revenues with the expenses incurred to generate them, providing a more clear picture of the profitability for each unit sold.
Better for planning – By recognizing future income and expenses, it allows for better long-term decision-making.
Cons
Complexity – Accrual accounting is more complex than cash accounting and requires more sophisticated bookkeeping.
Cash flow challenges – A business can appear profitable on paper but still face cash flow issues.
What Are the Differences?
| Cash Accounting | Accrual Accounting | |
|---|---|---|
| Timing of revenue recognition | When cash is received | When revenue is earned |
| Timing of expense recognition | When cash is paid | When expense is incurred |
| Financial picture | Provides a view of immediate cash flow | Provides a more accurate long-term financial picture and unit economics of the business |
| Compliance | Suitable for small businesses and individuals | Required for larger businesses and public companies |
| Accounts used | Primarily cash accounts | Includes accounts receivable, accounts payable, and other accrual accounts |
Which One Should You Choose?
Choosing between cash and accrual accounting for your books depends on your specific business circumstances. While we generally prefer accrual accounting because it gives a complete financial picture or narrative, the decision should be based on your business's unique situation.
For small businesses, sole proprietorships, or freelancers with simple transactions and no inventory, cash accounting might be the most practical choice. It's straightforward, easy to maintain, and provides a clear view of available cash.
However, as your business grows or becomes more complex, accrual accounting often becomes the better option. We generally recommend accrual accounting when:
Your business has inventory
You deal with accounts receivable and payable
You're seeking investors or loans
You're planning for long-term growth
Accrual accounting provides a more accurate representation of your financial health, which is crucial for informed decision-making and strategic planning.
That said, the benefits of accrual accounting should be weighed against its costs. While we prefer this method, it is usually more complex and therefore more expensive. You need to make sure that these expenses outweigh the benefits it will actually bring to your business.
Keep in mind, this is looking at it from a bookkeeping perspective. Although we do not usually recommend it, it is completely possible that you use one method to keep your books, and another to file your taxes.
Key Takeaways
Cash accounting recognizes revenues and expenses only when cash is received or paid, providing a clear view of immediate cash flow.
It’s simple to implement, offers immediate visibility of cash on hand, and can have tax benefits.
But it may misrepresent financial health, doesn't account for outstanding receivables or payables.
Accrual accounting recognizes revenues and expenses when earned or incurred, providing a more accurate long-term financial picture.
It offers better financial reporting and planning.
But it is more complex and can create cash flow challenges.
