Cash vs. Accrual Accounting in Plain English

As a small business owner or freelancer, keeping your finances in order is essential to running a successful business. But when it comes to accounting, one big decision you’ll face is whether to use cash accounting or accrual accounting. While both methods help you track income and expenses, they do so in different ways—and the choice can impact how you manage your finances and file your taxes.

In this article, we’ll break down the differences between cash and accrual accounting in simple terms, explaining what each method involves, how they affect your business, and how to choose the right one for you.

What is Cash Accounting?

Cash accounting is the simpler of the two methods. With cash accounting, you record income when you actually receive money, and you record expenses when you actually pay them. In other words, transactions are only recorded when cash changes hands.

Example of Cash Accounting:

• Income: If you send an invoice for $1,000 in June, but don’t get paid until August, you record the $1,000 as income in August (when the money hits your account).

• Expenses: If you receive a bill for office supplies in June but don’t pay it until July, you record the expense in July (when the payment is made).

Cash accounting gives you a straightforward view of how much money is actually in your bank account at any given time. It’s a great option for small businesses or individuals who want a simple way to track their cash flow.

Advantages of Cash Accounting:

• Simplicity: It’s easy to track income and expenses because you only record transactions when they happen.

• Cash Flow Clarity: Since income and expenses are recorded as cash moves in and out, you can easily see how much money is available at any given moment.

• Tax Benefits: For some small businesses, cash accounting can be beneficial at tax time because you can delay recording income until you’re actually paid (which can reduce taxable income in a given year).

Disadvantages of Cash Accounting:

• Incomplete Picture: Since cash accounting only tracks when money moves, it may not give you a full picture of your business's financial health. For example, you may have a large outstanding invoice that doesn’t show up in your books yet.

• Less Accurate for Long-Term Planning: Cash accounting may not provide the best insight into future expenses or expected income because it doesn't account for bills you owe or money you’re owed until the transaction occurs.

What is Accrual Accounting?

Accrual accounting is a bit more complex but provides a more complete picture of your business’s finances. With accrual accounting, you record income when you earn it (even if you haven’t been paid yet), and you record expenses when you incur them (even if you haven’t paid them yet).

Example of Accrual Accounting:

• Income: If you send an invoice for $1,000 in June, you record it as income in June, even if you don’t get paid until August.

• Expenses: If you receive a bill for office supplies in June, you record the expense in June, even if you don’t pay it until July.

Accrual accounting gives you a clearer view of your overall financial situation because it tracks revenue and expenses as they happen, regardless of when the money moves.

Advantages of Accrual Accounting:

• Complete Financial Picture: You can see a more accurate reflection of your business’s financial health since you’re tracking both expected income and upcoming expenses.

• Better for Long-Term Planning: Accrual accounting helps with forecasting because you know what revenue is coming in and what expenses are due, even if the cash hasn’t been received or paid yet.

• More Accurate Reporting: Accrual accounting is required for larger businesses and those with inventory because it provides a clearer picture of profits and losses over time.

Disadvantages of Accrual Accounting:

• More Complicated: It requires more tracking since you have to record income and expenses when they’re earned or incurred, even if the cash hasn’t moved yet.

• Cash Flow Confusion: With accrual accounting, it can be harder to know how much cash you actually have on hand. For example, you could show a large amount of income, but your bank account might be empty if you haven’t received payments yet.

Which Accounting Method Should You Use?

Choosing between cash and accrual accounting depends on the size of your business, the complexity of your operations, and your financial goals. Here’s a simple guide to help you decide:

• Use Cash Accounting if:

  • You’re a small business or sole proprietor with relatively simple finances.

  • You don’t have a lot of inventory or long-term contracts to track.

  • You want a clear, real-time picture of your cash flow.

  • You prefer a straightforward accounting method that’s easy to manage.

• Use Accrual Accounting if:

  • You have a larger or growing business, especially if you have more complex finances, long-term projects, or inventory.

  • You want a more accurate view of your business’s overall financial health.

  • You need to track your income and expenses as they’re earned or incurred for better financial reporting.

  • Your business is required by the IRS to use accrual accounting (businesses with over $25 million in revenue or those selling inventory must use accrual).

Can You Switch Between Cash and Accrual Accounting?

Yes, it is possible to switch between cash and accrual accounting, but you’ll need to notify the IRS if you make the change for tax purposes. Many businesses start with cash accounting when they’re small and then switch to accrual accounting as they grow and their financial needs become more complex.

Final Thoughts

The choice between cash and accrual accounting comes down to how you want to manage your business’s finances. If you need simplicity and a clear view of your cash on hand, cash accounting is a great choice. On the other hand, if you’re looking for a more detailed financial picture or if your business is growing, accrual accounting can offer valuable insights into your company’s long-term financial health.

No matter which method you choose, it’s essential to stay on top of your financial records to ensure you’re making informed business decisions.

Need help deciding which method is right for your business or managing your bookkeeping? Reach out to us for personalized advice!