Last editedMar 20222 min read
Accurate recordkeeping is a fundamental component of business accounting. When it comes to recording income and expenses, businesses have the choice between two accounting methods: cash accounting and accrual accounting. Keep reading to learn how cash accounting works, how it differs from accrual accounting, and whether it’s right for you.
Understanding cash accounting
Also called cash-basis accounting, cash accounting involves recording all revenues and expenses at the time that payment exchanges hands. By contrast, accrual accounting recognizes revenue and expenses when the bills are raised rather than when they’re paid. Cash accounting is the more simplistic of the two methods. Businesses only need to keep a cash account rather than separate accounts receivables and payables. Transactions are recorded using single-entry bookkeeping rather than double-entry.
For example, imagine that Company XYZ receives an order from a customer on April 15 to supply 20 laptops. The company fulfills the order and delivers the laptops on May 5, with the customer paying cash on delivery. Although the order was made in April, this transaction would be recorded on May 5 when the products were delivered and paid for.
What is the difference between cash accounting and accrual accounting?
There are a few key differences to be aware of when comparing the cash accounting and accrual accounting methods.
Records expenses when they are paid
Records revenues when payment is received
Uses the single-entry accounting method
Uses cash accounts for recording transactions
Records expenses when you place an order
Records revenues when a bill is raised
Uses the double-entry accounting method
Uses multiple accounts including Accounts Payable, Accounts Receivable, and cash accounts
Cash accounting is determined by a basic cash-in, cash-out system. You record revenue and expenses only when payment is received. Accrual accounting takes note of the transaction date and payment date separately, reconciling them with the double-entry bookkeeping method.
What is the difference between cash flow and profit?
There are two additional concepts to be aware of when looking at cash accounting.
Cash flow refers to money flowing in and out of your business during an accounting period. It does not take additional liabilities or credits into account. This is what you should be measuring for the purpose of cash accounting.
Profit or net income refers to the amount of money left over from revenue once costs have been taken out of the equation. This looks at the bigger picture including transactions over time, existing liabilities, and pending bills.
Pros and cons of cash accounting
For independent contractors and small businesses, there are a few distinct advantages to using the cash accounting method. It’s the easiest for beginners to grasp, only requiring maintenance of cash accounts to track revenue and expenses. You only need to record transactions when payment is paid out or received. This also makes filing your tax returns easier, and you can potentially reduce your bills by delaying invoices or payments. Another pro to cash accounting is that it makes it easier to keep track of your business’s cash flow. You’ll be better able to manage expenses with a current view of how much cash you have.
On the other hand, cash accounting won’t be right for all businesses. While it gives you a clear view of your cash flow, it doesn’t take all liabilities into account. You might have a number of debts to pay off which won’t be reflected in your current cash account. Cash accounting can also make your business look less profitable on paper if you’re waiting for delayed payments from customers.
Is cash accounting right for you?
If you’re just starting out with a small business, cash accounting might be the best option as you get on your feet. It simplifies your tax returns and helps you accurately track cash flow. However, under the Generally Accepted Accounting Principles (GAAP) corporations must use accrual accounting. The IRS also requires any business with over a $25 million turnover to use the accrual method. As your business grows, accrual accounting will be the better option.
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