Differences Between Cash and Accrual Accounting

Learn the differences between cash and accrual accounting methods and see how your online bookkeeper can help you keep up with all your online accounting demands.

Starting your business is reason enough for stress. On top of that, dealing with your finances and accounting on your own can only add to the headache. At Decimal, we want to help you simplify the process, and we’ve put this guide together to help you better understand your accounting. Here, we’ll lay out the differences between cash and accrual accounting methods and how to choose which is best for your business.

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Cash Vs. Accrual Accounting 

It's said that the advent of accounting is closely related to the invention of writing. Meaning for almost as long as we’ve been recording anything about our existence, we’ve been trying to keep track of our money. We started with simple systems; when resources entered the coffers, we wrote them down. When they left, we wrote it down.

Cash-based accounting is a method where revenues and expenses are only recognized when the cash exchanges hands. In other words, revenues and expenses are only recorded in the books when cash is paid out or received.

As our money systems and ownership structures became more complicated, we needed a more robust way of tracking it all. In the late 15th century, an Italian Friar by the name of Luca Pacioli recorded the methods used by Venetian merchants at the time. The Friar provided the first written account that introduced double-entry bookkeeping and the concepts of credits and debits. With those concepts came accrual accounting. 

Accrual accounting became necessary as the complexity of business transactions grew. It became the prevalent accounting method for larger companies (as well as some small ones) because it could depict a more accurate representation of a company’s financial health. Unlike cash-based accounting, accrual accounting tracked transactions as soon as they happened rather than when they were paid out. 

The main difference between cash and accrual-based accounting is the timing in which transactions are recorded. For example, let’s say you were to complete services for a client in June and didn’t expect payment until July. Under cash-based accounting, that transaction would not be recorded until July, when the cash is received. Accrual accounting, however, would recognize that transaction in June, when the obligations of the company have been fulfilled.

Pros and Cons of Cash Accounting

Cash basis accounting is mainly used by small businesses that need to keep track of their cash flow at all times. It tends to be easier as there generally is less to track; many small businesses and a large portion of Decimal Core clients use this method because of its simplicity. Cash-based accounting is particularly suitable for businesses that use cash regularly, such as retail, or primarily deal directly with individual customers (B to C). Because cash basis accounting generally recognizes all revenue as it is received and all expenses when the money is spent, businesses that use it have an easier time managing their cash flow effectively.  Whenever you look at your bank balance, you know exactly what resources are at your disposal. It also means that your revenue generally will not be subject to tax until the cash is in the bank (although there is also a concept of ‘constructive receipt’ for certain amounts available upon demand). 

The drawbacks of cash accounting, however, become more apparent as a business’s needs become more complex. While simple and easy to maintain, the cash basis of accounting does not always show an accurate image of the true financial state of a business. While it may show the cash on hand, the sales a company has recently made or incurred expenses that have not been disbursed will not be reflected in financial statements. This could lead to an inflated or deflated picture of the company’s financial performance depending on the number of outstanding invoices and bills. 

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Examples of Cash Accounting

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Types of businesses that would typically utilize cash accounting include small retail stores, food trucks, personal services businesses, or any other business with limited financial complexity. 

As an example, let’s say Tim is the proprietor of the Tasty Tornado food truck. It’s June 1st, and he’s been in business for several years and uses cash-based accounting. He used to pay his vendors when orders arrived, but after adding a catering aspect to his business, he had his vendors switch him to a net30 vendor terms. 

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Tim's Tasty Tornado Food Truck

Cash-Based Accounting Financial Statement

June 2023

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Starting Cash Balance: $10,000

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Revenue:

- Daily Sales: $20,000

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Expenses:

- Food Purchases: $8,000

- Gas and Maintenance: $1,500

- Rent: $1,500

- Utilities: $400

- Insurance: $200

- Salaries: $4,000

- Taxes: $1,000

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Net Income: $3,400

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Ending Cash Balance: $13,400

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Because cash accounting only records when payments are made or received, a statement like the above will more closely align itself with the company’s cash flow statement than accrual accounting might. Without looking at a cash flow statement, we can say with certainty that there is $13,400 in Tim’s account, where he started with $10,000.

That means we can tell with absolute certainty that Tim was profitable this month, right? Before his net30 switch, we may have been able to say yes, but even then, without much certainty. Because the Cost of Goods Sold expense is calculated based on the cost of the inventory sold during the month, and is not necessarily equal to the purchases made during the month, Tim may have outstanding debt owed to vendors that this sheet does not track. For Tim, this may not be a huge issue, as he would have access to previous statements and his other financial sheets that show a complete picture. 

But as more categories for potential debits and credits grow, so does the potential to skew or distort the business’s financial health. While cash accounting can show Tim a relatively straightforward picture of his business and track his cash flow more clearly, his ability to make future financial decisions or to see potential problems is reduced.

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Pros and Cons of Accrual Accounting

On the other hand, accrual accounting recognizes revenue when it’s earned and expenses when they are billed (or in some cases as earned by the counterparty). This type of accounting is more prevalent among larger businesses but is typically more complicated and, without the proper technology, more labor-intensive. Accrual accounting benefits companies that deal with higher quantities of transactions or have long-term contracts that tend to span over multiple periods. Contracting companies, professional service companies, subscription-based companies, and manufacturing companies are just a few types of businesses that would utilize accrual based-accounting.

Additionally, this method is actually required for businesses with sales revenue over 26 million dollars in a three-year period. Accrual accounting provides a more realistic financial view of a business over the long term and is especially helpful for companies with large amounts of inventory. 

Even though the accrual method tends to be more popular among large businesses, it does have its drawbacks. Unlike the cash basis method, the accrual accounting method does not actively track your cash flow. This can be very dangerous for businesses with a cash shortage in the short term as they can end up spending money they do not actually have. If they only focus on the long term, which looks profitable, they might run into a challenging situation with too many purchases. Stated differently, they have reported lots of revenue, but they haven’t been paid, so there is no cash in the bank to actively use. While using the accrual method, it is imperative to have someone tracking the incoming revenue and outgoing expenses to understand the actual cash position of the business.
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Payroll Accrual

An aspect of accrual accounting that highlights its complexity is payroll. Assume a company pays its employees on the fifth of the month for the prior month’s work. Because your employees have already earned their pay for the month, under the accrual method, you would need to account for the compensation you owe to them at the end of the month, days before they are actually paid. The amount owed is an accrued payroll liability for your business. If you expand this concept beyond payroll – for example, to utilities, rents, service contracts, leases, loans, etc. -  this begins to create a long list of expenses that need to be recorded as accrued expenses (or payables). This illustrates why accrual accounting can potentially be more labor-intensive and more expensive without the right processes in place.
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Examples of Accrual Accounting

Alright, let’s visit Tim’s Tasty Tornado food truck again. It's now July, and Tim has accepted his need to change his business to accrual accounting due to the new vendor terms. 

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Tim's Tasty Tornado - Accrual-Based Accounting

For the Month Ended July 31, 2023

Revenues:

Food Sales: $15,000

Catering Sales: $5,000

Total Revenues: $20,000
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Cost of Goods Sold:

Food Purchases: $6,000

Opening Inventory: $1,000

Closing Inventory: $500

Total Cost of Goods Sold: $6,500
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Gross Profit: $13,000

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Expenses:

Wages and Salaries: $3,000

Rent: $1,500

Insurance: $200

Utilities: $400

Licenses and Permits: $150

Equipment Maintenance: $250

Total Expenses: $5,500

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Net Income: $7,500

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Knowing it is accrual-based accounting, we can extrapolate from the above statement a clearer picture of what occurred only during the reported month. We know that the category for food purchases (and the majority of the other revenues and expenses)  likely only represents the purchases made for July, unlike the previous June statement which could have had invoices, accounts receivable, and accounts payable bleed in from the previous month of May. Therefore we can now say with much more certainty that Tim’s Tasty Tornado is likely a profitable one.

However, we do not have a clear picture of our current cash because, with this statement alone, there is no way to tell if the revenues or expenses have been cash reconciled. 
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Is Accrual Accounting in Accordance with GAAP?

Accrual accounting is in accordance with the Generally Accepted Accounting Principles (GAAP). The GAAP, which defines the accounting rules of the United States actually requires that publicly traded companies use accrual accounting when reporting. This is because accrual accounting provides a much more complete and comprehensive view of a company’s financial performance and condition than other accounting types. 

To understand more fully why accrual accounting is the preferred method of GAAP, we’ve outlined the GAAP’s major principles.

1. Principle of regularity: Dictates that an organization's accounting adheres to the standards and regulations of GAAP
2. Principle of consistency: GAAP requires that a company use the same accounting methods and procedures for every reporting period.
3. Principle of sincerity: This principle requires that financial statements accurately reflect the company's financial position.
4. Principle of permanence of methods: GAAP requires that accounting methods and procedures be consistent and constant across financial periods unless there is a valid reason for otherwise.
5. Principle of non-compensation: Under this principle, gains and losses from different transactions are fully reported with no prospect of debt compensation. 
6. Principle of prudence: The accounting entries under this principle should be timely and realistic. Basically, the numbers should be honest and current and avoid presenting any data that is based on speculation.
7. Principle of continuity: This principle assumes that a company will continue to operate in the foreseeable future, unless there is evidence to the contrary.
8. Principle of periodicity: GAAP requires that financial statements be prepared at regular intervals, for example, fiscal quarters or fiscal years.
9. Principle of materiality: This requires that financial statements disclose all relevant information that could impact an investor's decision to invest in the company. It is meant to prevent companies from omitting any information from their financial reports, regardless of the implications.
10. The Principle of Utmost Good Faith: all parties are assumed to be acting honestly.

While cash-based accounting may be in compliance with the majority of these principles, it can violate the principle of prudence. A cash-based accounting system can cause a delay in both revenue and expense reporting, thereby creating a false representation of a company’s financial standing. However, accrual accounting takes into account these sorts of discrepancies. This is the main reason that accrual accounting is the preferred method for GAAP.

Can You Use Both Cash and Accrual Accounting?

Technically, yes. There is a widely used style of accounting known as hybrid accounting or modified cash-basis accounting that combines aspects from both cash and accrual accounting. It should be noted, however, that many hybrid accounting methods are not consistent with the Generally Accepted Accounting Principles and may not be accepted by government entities for taxes and audits.

Hybrid accounting is useful for internal accounting and can take advantage of the benefits of both methods while minimizing the drawbacks. With hybrid accounting, a company may choose which types of transactions are done with accrual accounting and which are done with cash accounting.

Let’s go back to Tim one more time. Before 2023, when Tim still paid cash on delivery (COD), he was receiving his food orders daily. He decided to switch to a hybrid style of accounting as a way to close the gap between his credit card sales and his food purchases to analyze his daily sales. Because his credit card sales had a 2-3 day processing period, he chose to report his sales on an accrual basis and continue to report his purchases on a cash basis. Because he could record the sales before the cash hit his accounts, he could figure out his gross margins more clearly. 

The drawbacks to hybrid accounting usually end up being quite similar to those of cash-based accounting. For example, if we fast forward to June 2023, where Tim has vendor terms that delay payment, then a cash-based reporting on food purchases would no longer make sense. He would then need to switch fully to accrual-based reporting to report accurately. 
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How Can I Simplify the Bookkeeping?

As you may have noticed, the biggest difference between cash-based and accrual-based accounting is when you record the company’s transactions. If you are doing your bookkeeping on your own, it is important to know the ins and outs of each system. At Decimal, you get a dedicated bookkeeper who keeps track of your finances and records everything how you prefer and how your business needs it. Your accountant keeps track of and records all your transactions so you do not need to stress about it. With Decimal handling daily reconciliations, you can understand the current state of the business without having to invest the time. 

Contact us to get a free consultation and see how your accounting operations can be improved!