Cash basis accounting vs accrual accounting

Cash basis accounting and accrual basis accounting are two methods of recording transactions. The crucial difference between the two systems is the time when the transaction is recorded. If you record the transactions when you receive/pay money, it is cash basis accounting. And if you record them when you raise/receive an invoice, it is accrual accounting.

We will explore both these methods in detail and consider how each method affects your business.

Cash basis accounting

This method recognises expenses when they’re paid and income when cash is received. This method does not track accounts payable or accounts receivable.

A lot of small businesses rely on cash basis accounting as it is straightforward and pretty easy to maintain. It is quite easy to identify when a transaction has occurred (the money has been received/paid either in cash or in/out of the bank. This means that there’s no need to keep a track of payables or receivables.

Cash basis accounting also helps in calculating how much cash a business has at any point of time; you can simply look at the bank balance and you know how much money you have at your disposal.

Furthermore, as transactions are recorded only when the cash is received/paid, the income is not taxed until it gets to the bank.

However, cash accounting isn’t accurate. It may show a business as profitable even though it has huge bills to pay. It isn’t helpful when it comes to making management decisions; there’s not much you can decipher from a day-to-day view of your finances.

Accrual basis accounting

Under accrual basis accounting, you record revenues and expenses as they are earned irrespective of when you receive/pay the money.

For instance, you will record income when a project has been completed rather than when you receive payment. This method is the most favoured one compared to the cash method.

The biggest benefit is that this method provides a more realistic picture of income/expenses, providing a long-term view of the business that cash accounting does not offer.

However, this accounting method does not tell much about cash flow; a business may appear to be highly profitable where in reality its bank accounts are empty. Accrual accounting in the absence of careful tracking of cash flow could have catastrophic consequences.

Accrual basis accounting requires a lot of work as you have to keep a track of invoices, not just the bank account. What’s more, you may have to pay tax on your revenue even before the customer actually settles the invoices.

Which system should your small business use?

To identify which method suits your business best, consider:

• The size of your business

• The complexity of your processes and business transactions

• Whether relying on an electronic system would make a difference

• Whether you have the time and resources for accrual accounting

Cash basis method works well for small businesses that do not carry any inventory. If your business maintains a lot of inventory, your accountant will likely recommend the accrual method.

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