App version: 0.1.0

Small Business Cash vs Accrual Accounting

Small Business Cash vs Accrual Accounting
Lauren Ward
Lauren WardUpdated January 13, 2023
Share this article:
Editor’s note: Lantern by SoFi seeks to provide content that is objective, independent and accurate. Writers are separate from our business operation and do not receive direct compensation from advertisers or partners. Read more about our Editorial Guidelines and How We Make Money.
If you’re starting a small business, one of the many decisions you’ll need to make is whether to go with cash basis or accrual basis accounting. What’s the difference? With cash accounting, you record revenue and expenses when you actually receive or pay the money. With accrual accounting, on the other hand, you record revenue and expenses when you get a bill or send an invoice. Cash basis accounting is simpler and more straightforward, while accrual accounting can give you a more accurate look at your company’s big financial picture. Read on for a closer look at how each accounting method works, the pros and cons of each approach, and why you might pick one over the other.

What Is Cash Basis Accounting?

With cash basis accounting, you record your income and expenses only when money changes hands. You don’t count invoices you’ve sent out as income, or bills you’ve received as expenses, until they are settled. As a result, this approach lets you know exactly how much cash is available to your business at any given time. Because of its simplicity, many small businesses and sole proprietors use the cash basis method as their primary method of accounting. However, cash accounting is not accepted by the generally accepted accounting principles (GAAP). And the Internal Revenue Service (IRS) does not allow companies that have collected $25 million in gross sales in any one of the past three years to use cash basis accounting. Recommended: GAAP vs Non-GAAP 

Cash Basis Accounting Pros and Cons

Here’s a look at the advantages and disadvantages of using the cash method of accounting.

Pros

  • Similar to personal budgeting Cash accounting is done the same way you probably manage your personal finances. This can make it an easy way to manage your business finances
  • Easier to pay taxes You are taxed only on income received during the tax year, so cash accounting lines up with tax requirements. As a result, you’ll be less at risk of not being able to afford tax payments. 
  • Provides a clear view of cash on hand Cash basis accounting offers you a day-to-day snapshot of how much money your business actually has at any given time.

Cons

  • Doesn’t provide an accurate financial picture Since it doesn’t account for all incoming revenue or outgoing expenses, cash accounting can obscure your company’s actual financial position. 
  • Harder to track invoices and expenses Accounts payable and receivable aren’t tracked with cash flow accounting, so it can make it hard to know what invoices are outstanding and what bills are coming up. 
  • Difficult to transition to accrual accounting If you start out using cash accounting, it can be difficult to transition to accrual accounting later. If you think your business could exceed $25 million in sales in the not-too-distant future or plan to take your company public, you might consider opting for the accrual accounting method when you’re setting up your accounting system.

Cash Accounting Example

To illustrate how cash accounting works, let’s say you invoice a client for $1,500 on April 1 and receive payment on May 20. With cash accounting, you would do nothing in April. In May, you would record the $1,500 as income.You would take the same approach with expenses. Let’s say you mailed a check to a vendor on April 15 but they don’t cash that check until May. In your accounting software, that transaction would be counted for the day the funds left your account, not the day you wrote the check. 

Accrual Basis Accounting

With accrual basis accounting, you record revenues and expenses when they are earned or spent, regardless of when the money is actually received or paid. This means that you make a record of income even before it reaches your bank account, and you note deductions for bill payments and other expenses before they’re paid.When using the accrual method, you make use of an accounts receivable and accounts payable record in your books. An accounts receivable is money owed to your business for services rendered, while an accounts payable is money your business owes to vendors or creditors.Accrual basis accounting generally gives a more realistic idea of income and expenses during a period of time. Unlike cash basis accounting, however, it doesn’t give you a clear picture of how much cash you actually have on hand.Accrual accounting is often a must for larger businesses, as they tend to have too many moving financial parts to rely on the more simplistic cash-basis approach. It’s also required for publicly traded companies and firms that bring in over $25 million in revenue.

Pros and Cons of Accrual Basis Accounting

Here’s a look at the advantages and disadvantages of accrual accounting.

Pros

Provides an accurate snapshot of company financials This approach allows you to understand how income and expenses impact each other during the window in which they’re actually incurred, not when the transactions post to your business bank account.Makes it easier to qualify for loans or attract investors When you have a better understanding of your financial position — and can show solid evidence that your business is profitable — it can be easier to convince investors and lenders to take a chance on your company.No need to change accounting methods when your business grows The accrual method is the required accounting method for businesses that make over $25 million a year. Starting with the accrual method saves you the hassle of making the switch.

Cons

It’s more complex Even if you’re good at bookkeeping, you’ll likely need to find an accountant experienced with accrual basis accounting to accurately track your company performance.Numbers are different from bank accounts You (or your accountant) will need to track your cash flow separately because your balance sheet won’t reflect what’s actually happening in your bank accounts.Can trick you into thinking you have more money than you do Because you’re recording invoices that haven’t been paid yet, the accrual method doesn’t reflect money that’s actually available. This could give you a false sense of security. 

Example of Accrual Basis Accounting

Using the same example as above, let’s say you invoice a client for $1,500 on April 1. With accrual accounting, you would record that $1,500 as income in April’s bookkeeping, even though the funds are not in your bank account (and won’t be until May).You would use the same approach with expenses. If you mail a check to a vendor on April 15 and use accrual accounting, you would record it as an April expense, even if the vendor doesn’t cash that check — and the money doesn’t leave your account — until May.

What Does It Mean to Record Transactions?

Whether you use cash or accrual accounting will have a major impact when you record a transaction. But what exactly does it mean to record a transaction?Businesses record all of their financial transactions in a general ledger. This provides one central place to add up all your income and expenses. You’ll need this information to file your taxes and claim any tax deductions at the end of the year. With single-entry bookkeeping, each transaction is recorded as a single entry in a journal. This is a simple and straightforward method of bookkeeping and is often used with cash accounting. For the most accurate financial statements, accountants will use double-entry bookkeeping. With this method, a credit is made in at least one account, and a debit is made in at least one other account. These two entries are equal and opposite. Listing everything twice can help companies catch errors and prevent fraud. Accrual accounting uses the double-entry bookkeeping method.Recommended: Small Business Accounting Basics 

Cash vs Accrual Basis Accounting: Cash Flow

Many small businesses find that it’s easier to track cash flow with cash accounting than with accrual accounting. Since you are recording transactions as they happen, your balance sheet should accurately reflect your business bank account. This can make it easier for you to plan for upcoming expenses, because you know exactly what’s in the bank. With accrual accounting, on the other hand, it can be more difficult to track cash flow, since you aren’t recording transactions as they occur. As a result, cash flow needs to be a separate calculation, which creates more work for you or your accountant.

Cash vs Accrual Basis Accounting: Taxes

When it comes to paying taxes, the cash accounting method can be simpler and more straightforward. It can also offer more flexibility, since you can control the timing of income and deductible expensesFor example, cash accounting allows you to defer income to next year by delaying invoices. You can also shift deductions into the current tax year by accelerating the payment of expenses. The accrual method can also offer some tax advantages, however. You may, for example, be able to use certain tax-planning strategies that aren’t available to cash-basis businesses, such as deducting year-end bonuses that are paid within the first few months of the following year, and deferring income on certain advance payments.

Is Cash or Accrual Accounting More Common?

The accrual method is the more commonly used method by large companies, especially by publicly traded companies, while the cash basis method is often preferred by sole proprietors and smaller businesses.

Choosing Between Cash vs Accrual Accounting

Most top accounting software programs make it easy to choose either cash or accrual accounting. The question is, which one should you pick? Here are some factors to consider.

Business Complexity

If you own a new or very small company that mainly does business through cash transactions, and you don’t maintain large inventories of products, you may prefer the cash system of accounting. This method can be a convenient and reliable way to keep tabs on revenue and expenses without the need for a lot of complex bookkeeping.If, on the other hand, you own a business with multiple accounts and hundreds of employees, you’ll likely want to avoid cash basis accounting because it won’t give the big-picture view you’ll need when preparing key financial statements for your business.

Sales Revenue

How much you earn in sales will also play a role in which accounting method to use. According to the IRS, if you exceed $25 million in annual revenue, then you are required to use the accrual method. For many small businesses, this isn’t an issue. However, it might be in the future, so it’s something to keep in mind. 

Publicly Traded or Privately Held

If you own a publicly traded company or one that may go public in the future, you will want to choose accrual-based accounting. Publicly traded companies have a duty to report an accurate view of their financial well-being to shareholders. These companies must comply with GAAP and use the accrual basis of accounting for both financial reporting and tax purposes.

Hybrid Accounting Methods

Some businesses opt to use a hybrid accounting system, also known as modified cash basis accounting, that combines elements of both cash and accrual accounting. This approach strives to get the best of both worlds, by recording sales and expenses for long-term assets on an accrual basis and those for short-term assets on a cash basis. A hybrid approach can give you a clearer financial picture of your business without having to go through the effort and cost of switching to full-blown accrual basis accounting. However, using two methods can be complicated and a hybrid approach is not accepted by GAAP.For most business owners, choosing either the cash or accrual method and applying it consistently can often be the best option.

Switching From Cash to Accrual Accounting

Many sole proprietors and small businesses start with cash basis accounting. However, it may be necessary at some point to convert to the accrual basis of accounting, perhaps in preparation for a sale, to go public, or to get a business loanUnfortunately, switching from cash to accrual accounting isn’t as simple as updating your software or telling your accountant to make the change. You actually need permission from the IRS (for which you use Form 3115). You’ll also need to provide the IRS with an adjustment that compares your accrued income and expenses to your cash-basis income and expenses for the tax year in which you want to make the switch.

The Takeaway

Both cash and accrual basis accounting help you track your business’s growth. Which method makes the most sense will depend on the size and complexity of your business. The accrual method is the more commonly used method by large companies, since it evens out earnings over time. The cash basis method, on the other hand, is often used by sole proprietors and smaller businesses. Should your business ever reach $25 million in gross sales or you want to take your company public, however, you’ll be required to use accrual basis accounting.Ready to take your business to the next level? With Lantern by SoFi’s easy-to-use online lending platform, you can access multiple business loan offers matched to your company’s needs and qualifications. 

Frequently Asked Questions

Is cash or accrual accounting better?
Should small businesses choose cash or accrual accounting?
Do most companies use cash or accrual accounting?
Tax Information: This article provides general background information only and is not intended to serve as legal or tax advice or as a substitute for legal counsel. You should consult your own attorney and/or tax advisor if you have a question requiring legal or tax advice.External Websites: The information and analysis provided through hyperlinks to third-party websites, while believed to be accurate, cannot be guaranteed by SoFi. Links are provided for informational purposes and should not be viewed as an endorsement.
Photo credit: iStock/Иван Карасев
LCSB0622023

About the Author

Lauren Ward

Lauren Ward

Lauren Ward is a personal finance expert with nearly a decade of experience writing online content. Her work has appeared on websites such as MSN, Time, and Bankrate. Lauren writes on a variety of personal finance topics for SoFi, including credit and banking.
Share this article: