Cash vs Accrual: The best accounting method for running a business

Video Highlights

1:07 Overview of the Cash Method

3:25 Advantages of the Cash Method

6:04 Disadvantages of the Cash Method

9:06 Overview of the Accrual Method

12:42 Advantages of the Accrual Method

13:58 Disadvantages of the Accrual Method

16:19 Accounting Method Comparison Chart

16:50 Should my business use the Cash or Accrual method?

18:17 Which method does the IRS require my business to use?

18:51 Example – dive deeper into the differences and test your skills

25:51 Compare profit and loss statement based on each accounting method

27:07 See the difference in action with an example at the Project level

31:45 Recap

32:34 The Bottom Line

The accounting world provides two methods for recording revenue and expenses – Cash and Accrual. Please don’t stop reading…I promise you this will be quick and painless. It is important for you to understand the difference between the two accounting methods, so you can join the conversation when you meet with your bookkeeper, CPA and banker.

Spoiler alert – it’s only a timing difference. The difference in the methods is simply when you record revenue and expenses.

Your choice affects not only your financial statements but also your tax return.

Cash Method

The Cash Method works the way the name implies…it follows the flow of cash moving in and out of your business.

Revenue is recorded when you receive the payment from customers.

Expenses are recorded when you pay your vendors.

The Cash Method is similar to the way you track your personal finances. When you receive a deposit in your personal bank account, you record the transaction in your checkbook. When you write a check to pay your mortgage, you record the transaction in your checkbook.

The same logic applies to your business checking account when you use the Cash Method. When cash changes hands, the transactions are recorded in your accounting system. You’re essentially tracking the transactions based on the activity in your business checking account.

Advantages of the Cash Method

Simple to maintain.
Easy to determine when to record the transactions.
Profit and cash are more likely to align with each other. (link to profit vs cash)
You have more control over your tax planning. You can delay issuing invoices until the first week of January and you can prepay expenses in December that you know you’ll need to pay soon after the first of the year.
You are more likely to have the cash you need to pay your income taxes, since you only record revenue when you receive the payment.

Disadvantages of the Cash Method

The lack of matching principle makes it difficult to easily see whether you made money or not. You’ll see a large swing in net income everyone month, if you provide services in one month, you pay your vendors in the following month…thanks to 30-day terms, and you collect the payment two months later.
Balance sheet does not include the Accounts Receivable and Accounts Payable accounts. Your bookkeeper will need to manually track the amount your customers owe the business and how much you owe your vendors. The lack of an Accounts Receivable report can cause cash flow problems because you cannot quickly see who owes money, how much and how long they are past due. Too many slow paying customers will create a cash crunch for you which may slow down your ability to pay your bills on time.
Difficult to manage cash flow with this method – even though this method naturally follows the flow of cash…it is focused on the historical information. It will not help you quickly see how much your customers owe you (Accounts Receivable) or how much you owe vendors (Accounts Payable). It may be cheaper on the front in because you’re practically maintaining a checkbook, but this method may hurt your ability to manage cash flow and make real-time financial decisions.
Provides an incomplete, short-term view of the company’s business finances.

Accrual Method

The Accrual Method fixes the timing differences that are naturally in the Cash Method. The Accrual Method requires you to record revenue when you earned it regardless of when your customer actually pays you. Expenses are recorded when they are incurred regardless of when you pay the vendor.

Typically, you earn revenue when you provide a service and you have good reason to believe you will receive payment. The invoice date on your customer’s invoice determines the date your company recognizes revenue under the Accrual Method.

Since the Accrual Method records transactions before cash has changed hands, your accounting system will automatically charge Accounts Receivable and Accounts Payable. Think of these accounts as a holding account. They take the place of cash until cash actually changes hands.

When an invoice is created for a customer, your accounting system will automatically increase Accounts Receivable and Sales. The amount your customer owes you is recorded in a holding account, Accounts Receivable, until you receive payment.

The Accounts Receivable report will help you track the customers that owe you money.

Expenses follow the same logic except the invoice date on the vendor’s invoice determines the date you recognize the expense.

When a vendor invoice is entered in to your accounting system, the Expense and Accounts Payable accounts are automatically increased. The amount you owe to the vendor is recorded in the holding account, Accounts Payable, until you pay the invoice.

By entering your expenses with the Accrual Method, you are allowing your expenses to match the revenue that was generated.

The Accounts Payable report will help you easily track the vendors that you owe money to and project your cash flow needs.

Advantages of the Accrual Method

Balance Sheet is more complete because it reports Accounts Receivable and Accounts Payable.
A more accurate picture of profitability is reported on your Income Statement because the accrual method naturally matches profit to related expenses.
Your accounting system will automatically track Accounts Receivable by customer and Accounts Payable by vendor so you can easily print a report to help you manage cash flow and collections.
Quickly see red flags before they become an emergency.

Disadvantages of the Accrual Method

More complex method that requires training to understand how timing affects transactions.
Income statement can report a profit, but in reality, you are running out of cash.
You may pay tax on revenue that has not converted to cash because the customer has not paid. Their balance is stuck in the Accounts Receivable account.

Accounting Method Comparison Chart

Should my business use the Cash or Accrual method?

Even though we’ve never met, I encourage you to consider using the Accrual method for operations and the Cash method for tax purposes (if your business qualifies) – this is the best of both worlds.

Yes, you can choose the method you use for operations and it can be a different method than your tax return. The financial statements for your company are YOUR financial statements. It is important that you choose a method that supports your ability to make quick financial decisions.

Don’t worry about higher tax return preparation fees. It is easy for your tax accountant to convert your books from the Accrual Method to the Cash Method for your tax return. Most accounting software programs automatically track both methods for you, so your accountant can simply print the Cash version to start their work.

Which method does the IRS require my business to use?

The IRS allows businesses to use the cash accounting method when gross annual revenue does not exceed $25 million and the business does not carry inventory. Please discuss your options with your tax accountant to determine your filing requirements.

The Bottom Line

The Accrual method is the most reliable method for running your business. Your financial statements will paint a more complete, accurate picture since the revenue and the related expenses are matched in the same month. You’ll have the information you need to quickly make decisions, see which customers owe you money and how much you owe vendors.