Cash vs. Accrual Accounting: What to Know About (& When to Use) Each Method

As businesses grow, they inevitably handle more transactions and more moving pieces, making modern accounting more complex. Understanding and choosing the right accounting method (cash vs. accrual) impacts how to track cash flow in and out of the business and its overall financial health. This article explores more about each method, how they differ, and how modern software and tools can help lower the barrier to entry for more comprehensive accounting and financial reporting.

Key Takeaways

1. Cash basis accounting is simpler and reflects actual cash flow, while accrual provides a clearer overall picture of profitability.
2. Accrual accounting suits larger, inventory-based businesses while cash basis works better for small, service-based businesses.
3. Accounting software typically supports both methods, automating tracking and improving analysis and tax management.

What is Cash Basis Accounting?

Starting with the simpler of the two methods, cash accounting (also known as cash basis accounting) records income and expenses at the time they are paid or received. This means that delayed payments like credit or loans are recorded at the time of payment, not at the time of the transaction. The result is a much simpler accounting process that’s ideal for smaller businesses that have straightforward transactions and payment terms.

Example

Let’s say you invoice a client for $5,000 on June 8th, but receive the payment on June 24th. Cash basis accounting would record the income from this transaction on June 24th (when you received payment), not June 8th. This also goes for expenses and cash outflow. If you purchase office supplies on July 1st but don’t pay until July 30th, cash basis accounting records that expense on July 30th.

Benefits

• Simplicity: Cash basis account is easier to manage because transactions are only recorded when money changes hands, eliminating deferred payment complexities.
• Clear Cash Flow: This method also provides a transparent picture of how much cash a business has on hand at a given time.
• Lower Tax Burden: Taxes aren’t paid on income until it’s actually received, enabling businesses to control the timing of income and deductions.

Drawbacks

• Limited Insights: Because cash-basis doesn’t show what you owe or what is owed to you, it doesn’t provide the full picture and makes long-term planning difficult.
• Potentially Misleading Profitability: It only reflects cash activity, so businesses might look weaker or healthier than they are, depending on the timing (e.g. if the business just paid wages but is also waiting on an outstanding invoice to be paid).

What is Accrual Accounting?

On the other hand, accrual accounting records income and expenses when they’re earned (or accrued) rather than when cash changes hands. Using this method provides a more accurate and comprehensive view of a company’s financial health because it includes what you owe and what is owed to you. However, balancing this additional information and delays between accruing income/expenses and actually receiving/paying that money complicates the accounting process (especially if done manually).

Example

Using the same example as cash accounting, if we send an invoice to a client for $5,000 on June 8th but don’t get paid until June 24th, accrual accounting will still record the income on June 8th (even though this is before you receive the money). If you purchase office supplies and receive the bill on July 1st but don’t pay it until July 30th, this expense is still recorded on July 1st, even though you don’t part with the cash until the 30th.

Benefits

• More Accurate: Because accrual accounting reflects income and expenses as they occur, it provides a clearer picture of profitability and financial health.
• Better Long-Term Planning: With a clearer picture, this method is more effective for long-term strategic decisions.
• Compliance with Regulatory Standards: Beyond business benefits, companies that adhere to GAAP (Generally Accepted Accounting Principles) are required to use accrual accounting for standardized compliance purposes.

Drawbacks

• More Complex: Tracking accounts receivable and accounts payable can be time-consuming and headache-inducing without the right tools.
• Tax Liability Timing: Because earnings are often recorded before payment is actually received, you may owe taxes on income that hasn’t arrived yet.

Cash vs. Accrual Accounting: What are the Differences?

To recap, both accrual and cash basis accounting are methods for recording transactions, income, and expenses — but they differ in several key areas.

The main difference between these is the timing of transaction recording. Cash basis accounting records income and expenses when cash changes hands (i.e. when cash is actually received or paid), while accrual accounting records this when they are earned (i.e. when a transaction happens or when an invoice is sent).

This core difference then leads to other contrasts between the two methods, such as their complexity. Cash basis accounting’s reliance on actual cash flow makes it simpler to record and follow, whereas accrual accounting’s tracking of receivables and payables introduces significantly more complexity.

Cash basis accounting comes with the drawback of a more limited picture of financial health and profitability. The intricate nature of accrual accounting means that it offers a much more accurate view, which can be beneficial for long-term planning and strategic decision-making.

Lastly, there are also potential tax implications of the timing of each method. With cash accounting, taxes are only owed on payments you have received, while the receivables and payables of accrual accounting may result in paying taxes on income that has not been received yet.

Which Should You Use?

Several considerations will affect this decision, such as business size, organizational complexity, financial goals, kept inventory, and more. While every business has different goals and objectives, there are a few guidelines that can help decide which accounting method is right for the job.

When to Use Cash Basis Accounting

Small businesses and freelancers with few transactions are the ideal candidates for cash basis accounting. These tend to be simpler and often don’t need to track receivable and payable accounts extensively.

Another good candidate for this type of accounting is service-based companies that don’t carry inventory. These businesses also primarily rely on service income, which is more directly reflective of cash flow.

Lastly, cash basis accounting can be useful if your organization has specific tax goals to reduce the year’s taxable income. By controlling when you receive payments, such as delaying until after the tax year, this accounting method could be a useful tool in these situations.

When to Use Accrual Accounting

Large businesses (with more than $25 million in revenue over three years) and those that follow GAAP or IFRS are mandated to use accrual accounting, but there are a few other situations where accrual accounting can be beneficial.

Companies that keep and manage inventory may find accrual accounting useful to provide a clearer picture of stock-related expenses and sales. The cash flow for these businesses is often not directly representative of actual financial performance (they may operate largely on credit), so cash basis accounting wouldn’t capture an accurate picture.

Long-term contracts or subscription-based models also benefit from accrual accounting because services (like software or consulting) are delivered over time. This payment structure more closely aligns with accrual by helping to match income to specific service periods.

Hybrid Accounting: Best of Both Worlds?

It’s worth briefly mentioning that some companies use a hybrid approach to accounting. In other words, they use a cash basis for tax reporting simplicity and control, but might still track receivables and payables using accrual accounting for internal planning. This offers more flexibility than either method on its own but often requires advanced accounting software. However, it should be noted again that any company adhering to GAAP or IFRS is required to use accrual accounting anyway, so there is less upside to hybrid accounting in these instances.

How Can Accounting Software Help?

This is where modern accounting, revenue management, and tax tools come in handy. Gone are the days when businesses can manually track income, expenses, receivables, payables, and tax deductions by hand with pen and paper. Today, companies require more efficient and organized tools that not only save time and headaches, but also ensure compliance with regulations and minimize the risk of human error.

Accounting software like QuickBooks, Xero, Sage, NetSuite, and Workday provide massive benefits to the companies that use them. For example, a common feature of these platforms is automatic transaction tracking that records and categorizes income and expenses based on your preferred accounting method. Many tools also allow you to switch between cash and accrual to check how either method affects your financials. On top of tracking, modern accounting and financial software generates reports based on real-time data (such as cash flow and profitability), keeping stakeholders in the loop and informed. Lastly, many platforms include (or integrate with) tax management tools to simplify the process and ensure compliance without overpaying.

Find the Right Accounting Tools

There are a lot of accounting tools available, so how do you know which is the best for your business? TrustRadius collects verified reviews from real users across thousands of products to help inform your decision — and companies can’t pay for placement. Whether you’re looking to start your research, or you already have a shortlist, our tools enable you to identify which platforms are best suited to your needs. 

Looking specifically for accounting software for small business owners in the service industry? Or perhaps what enterprise reviewers think about a certain product? Browse and filter the products and reviews across our site to start your list, narrow it, and find the best final choice for your business. Ready to start evaluating? Look through some of the relevant categories below:

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