Cash vs. accrual accounting: Differences, pros, and cons of both

Businesses of all sizes need to account for their revenue and expenses by recording all financial transactions, both outgoing and incoming. Doing so allows a company to keep track of the money that flows out of its accounts to pay vendors and suppliers and the money that flows into its accounts from customers, whether those customers are consumers or other businesses. But should your company use a cash basis accounting system or accrual accounting?

Accurate and up-to-date accounting ensures that both company insiders (like accountants and finance officers) and company outsiders (like investors, regulatory agencies, and the IRS) can get an accurate picture of a business’s financial health. It also tracks cash flows and important documents like balance sheets and income statements use these numbers accurately.

Related: History of accounting: Timeline

Nearly every business accounts for revenue and expenses in one of two ways — cash basis accounting or accrual basis accounting. Both of these methods record all incoming and outgoing cash flows, but they differ in when these cash flows are recorded.

A quick guide to cash vs. accrual accounting

What is cash basis accounting?

Cash basis accounting, or simply cash accounting, is a method that records all revenue and expenses at the time money changes hands — regardless of when a product or service was received or delivered. In other words, it records payments (both incoming and outgoing) when they occur, not when they are incurred.

Put simply, cash basis accounting records expenses when payment is sent and records income when payment is received. Cash accounting doesn’t care when a product changes hands or when a service is conveyed — it only cares when cash changes custody.

An example of cash basis accounting

For example, let’s say a small local grocery store chain places an order with a fruit distributor for six pallets of mangos. The distributor prepares the order while its accounts receivable department bills the client. Soon, the fruit distributor delivers the mangos, and shortly after this, the grocery chain receives a bill for the delivery from the distributor with instructions and a deadline for payment. A week or so later, the grocery chain’s accounts payable department sends payment for the mangos to the distributor.

If the fruit distributor in question uses the cash basis accounting method, it would not record the income for the mangos when the order is received or when the goods are delivered — it would wait to record the income until payment from the grocery chain landed in its account, marking the successful completion of the transaction.

This means that if the order was placed during the last week of July, and the mangos were delivered that week as well, but payment for the order wasn’t received until the first week of August, that payment would be recorded as August income for the fruit distributor.

What is accrual basis accounting?

Accrual basis accounting, or simply accrual accounting, is a method that records all revenue and expenses when they are incurred, regardless of when payment is made. In other words, the moment a product or service is billed, a transaction is recorded, even if payment has yet to be sent or received.

An example of accrual basis accounting

Let’s return to the example above in which a regional grocery chain orders six pallets of mangos from a fruit distributor. Using accrual accounting, the fruit distributor would record the revenue from the mango order as soon as they create the bill to send to the grocery chain, before the mangos are delivered, and well before payment is received.

In this example, if the order was placed in July, but payment wasn’t received until August, the transaction would still be recorded as July revenue.

Cash vs Accrual

These are 2 different methods in which you can present your financial statements…

Cash Basis → focuses on money in vs money out

Accrual Basis → focuses on income earned vs expenses incurred pic.twitter.com/dlcgEmjhFF

— Josh (Your CFO Guy) (@YourCFOGuy) September 12, 2023

Which accounting method is better?

Neither cash nor accrual accounting is inherently superior, and a business may choose one over the other for various reasons. That being said, all publicly traded companies and all businesses with over $25 million in annual revenue are legally required to use the accrual accounting method in order to comply with generally accepted accounting principles (GAAP).

For any business that sells physical products, accrual accounting is usually preferable because it aligns incoming money with outgoing merchandise, allowing the cost of goods sold (and thus, gross profit) to be accounted for in an accurate and timely manner.

Additionally, any company that buys or sells goods or services on credit might benefit from the accrual accounting method because it aligns revenues and expenses with the months and quarters in which they were incurred, regardless of when payment was remitted. This means that monthly and quarterly financial data won’t be skewed by lagging payments.

All this being said, small, service-based businesses that only deal in cash may prefer the cash accounting method, as it is less time and labor-intensive (and thus less expensive in terms of staff and hours). In general, however, most businesses that hope to grow over time will eventually need to adopt the accrual method, so using it from the get-go can help a company avoid the hassle of an unwieldy transition down the line.

You can weigh the pros and cons of a cash vs. accrual accounting practice to decide what’s best for your business

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