Cash Basis vs. Accrual Accounting -
Which one is right for you?
When deciding what type of accounting method to use for your business or nonprofit, it is important to understand how each method works.
The difference between the two methods of accounting – cash basis accounting and accrual accounting - is when revenue and expenses are recorded. A business using cash accounting records revenue and expenses only when cash changes hands, while accrual accounting records revenue at the time it’s earned and expenses when they’re incurred.
We’ll provide an overview of the two methods below along with the pros and cons of each so that you can make the best decision for your business.
For many small businesses and nonprofits, managing cash flows is a vital consideration. This is why many choose to use the cash basis of accounting. This method is also simple to use as it records revenue when cash is received, and expenses when they are paid and does not utilize accounts receivable or accounts payable. There are cash flow benefits to this method as well, as it does a better job ensuring income is not taxed until it is already in the bank. It also offers some tax planning flexibility, allowing income to be deferred into the next tax year by delaying invoices to clients and deductions to be accelerated by paying expenses early. Although this method is simple, it provides a limited look at your expenses and income. Cash basis accounting does not record liabilities or amounts owed by customers, since many businesses extend credit to their customers and incur debt to finance their operations, this may lead owners to misunderstand the true financial position of their business.
Despite the accrual method of accounting being a little more complex than the cash basis, it provides a more accurate picture of revenue and expenses currently and more insight into business performance in the long run. This insight also allows for more meaningful comparisons across months, quarters or years since performance will not be affected by the more random nature of cash transactions. Accrual accounting also makes planning easier as business owners using this method can create forecasts to help with staffing and inventory decisions. While accrual accounting does offer a more accurate picture of the profitability of the business, owners must monitor cash flows carefully as it does not provide the same awareness of cash as the cash basis.
There is another alternative; the hybrid method of accounting is a combination of the cash and accrual methods. Using this system, a business can utilize accrual accounting for some aspects of the business and cash basis for others. This method maintains some of the ease of cash accounting along with the cash flow benefits and potential tax flexibilities. It also allows the business to closely track both cash balances and outstanding credit and debt, allowing for more accurate forecasts and reliable projections. This method works well for many small and mid-sized businesses and nonprofits as it allows a focus on the long term outlook while focusing on present cash flows to ensure they are adequate for current business needs.
Please note, this information on this website does not constitute legal advice. It is provided for general information purposes only.