As a business owner, it’s vitally important to keep track of your business’s expenses. Fortunately, this doesn’t have to be a challenge. There are two primary accounting methods that you should know about: cash basis accounting and accrual basis accounting.
You’ve probably heard people talking about the differences between these two systems, but if you’re not an accounting professional, it can be difficult to get a proper sense of cash basis accounting vs. accrual basis accounting. In a nutshell, it all comes down to timing. Check out our guide for a little more information.
Definition of cash basis accounting
Cash basis accounting recognises income and expenses when the money changes hands, but not before. As a result, invoices are not considered to be income and bills are not considered to be expenses until after payment has been settled. While the cash basis accounting method is simple to maintain (there’s no need to track payables or receivables), it’s not entirely accurate, because it could indicate that you’re in good financial health despite having several large bills right around the corner. On the other hand, cash basis accounting does provide you with a more useful overview of cash flow and the amount of cash that’s available to you at any one time.
Accrual basis of accounting definition
Accrual basis accounting recognises income as soon as an invoice is raised, while bills are recognised as expenses as soon as they’re received. This is the case even if the money won’t leave/enter your account for the next 30 days. Overall, accrual basis accounting provides a more accurate view of your business’s finances that should enable you to make financial decisions with greater confidence. However, it does require more work on the front-end as you’ll have to take a more active approach to recording invoices. Furthermore, accrual basis accounting doesn’t give you a particularly strong insight into your company’s cash flow, as your business may appear to be profitable while having almost nothing in the bank.
Accrual basis accounting vs. cash basis accounting: what’s the difference?
As we mentioned earlier, the key distinguishing factor when it comes to cash basis accounting vs. accrual basis accounting is timing. Here are some of the things you should pay attention to when deciding which accounting method to use:
Recognising income when the invoice is raised, rather than when the money actually changes hands, helps to ensure that you have the most accurate picture of your business’s financial health, which is why accrual basis accounting is generally considered to be the more powerful accounting method.
Having said that, there may be a tax advantage to cash basis accounting – if you sent an invoice in 2020 but don’t get paid until 2021, then the tax won’t need to be paid until the following year, which can be extremely beneficial for smaller businesses with limited cash flow.
It’s also worth noting that accrual basis accounting is mandatory in the US for companies with over $25 million in annual sales, as it conforms to the generally accepted accounting principles (GAAP). However, if you don’t make that many sales or you’re not based in the US, that’s not something you’ll ever need to worry about.
Ultimately, whether your business uses accrual basis accounting or cash basis accounting comes down to your business goals and financial requirements. Accrual basis accounting is generally thought of as providing a better indication of your business’s financial health, and while it’s more complicated to implement than cash basis accounting, the additional insight it provides is worth the additional effort. Plus, with modern accounting software, your technology can do most of the work for you. However, cash basis accounting probably is a better option than accrual basis for smaller companies, as the additional insight into cash flow is likely to be necessary for businesses with tighter margins.
Want to learn more? Read our guide to Accruals.
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