Cash Basis
Cash basis is a method of accounting that recognizes revenue when cash is received and expenses when cash is spent. Even if an invoice is sent out to a customer or a bill is received from a vendor, revenue is not recorded until payment is received from the customer and the expense is not recorded until the bill is paid to the vendor.
Accrual Basis
Accrual basis is a method of accounting that recognizes revenue when it is earned and expenses when it is incurred. For example, if a landscaping business mows a customer’s lawn, once the service is complete, they recognize revenue even if they haven’t received payment yet from the customer. If a business pays for rent in advance, the expense is recognized on the books for the month that the rent is applied to, not when the rent was actually paid.
There are some key differences between accrual basis and cash basis that small businesses should consider when doing their bookkeeping which are discussed below.
1. Matching Principle
Under the accrual basis of accounting, related revenues and expenses are matched in the same period that they occur. This is known as the matching principle. Cash basis records revenue when cash is received and expenses when cash is paid regardless of the period that they occur.
2. Complexity
The cash basis of accounting is usually simple and easier to manage, while the accrual basis of accounting uses more advanced accounts like accounts payable, accounts receivable, and long-term liabilities.
3. Accuracy
Accrual basis offers a more accurate view of the performance and financial health of a company since it tracks accounts receivable, accounts payable, and other advanced accounts like deferred revenue. Cash basis can give an inaccurate impression of long-term profitability. For example, a sale can occur, and an invoice is sent to a customer, but the revenue is not recorded yet until the customer pays which, in some cases, can be for a significant amount of time.
4. Compliance
There are a few considerations business owners should take into account when choosing to use cash basis or accrual basis. According to the IRS, certain small business owners can select any method as long as they adhere to it, and it correctly depicts how the business operates. Generally accepted accounting principles (GAAP), states that companies that file audited financial statements are required to use the accrual method. Companies that have inventory should always use the accrual method to accurately match the cost of goods sold with the sales related to it in the same period.
The decision to choose between cash basis and accrual basis of accounting ultimately comes down to the particular needs of a company and business owners should carefully assess what is suitable for them.
