you’re playing cards, baseball or Candy Crush Saga, you’re not going to be
successful unless you understand how to keep score.
The game of business is no different. The only problem is that the way you keep score—accounting and bookkeeping—can be quite complicated. In a recent tutorial, we covered the basics of bookkeeping, but there’s one crucial part we didn’t mention: the difference between cash and accrual accounting.
So in this tutorial, you’ll learn how both cash accounting and accrual accounting work. You’ll see examples of each technique in action, learn their pros and cons, and be ready to decide which one you should use for your business.
It may sound quite esoteric, but if you own a business, it’s something you need to understand. As you’ll see in this tutorial, if you’re not recording transactions the right way, you could end up misrepresenting the true state of your business. That will make it more difficult to plan, could affect how much tax you pay, and in extreme cases it could even put you out of business altogether.
Step 1: What is Cash Accounting?
Let’s say you run a consulting business, and in the month of September you land a juicy $50,000 contract with a Fortune 500 company. Congratulations!
But you don’t receive the money right away. You deliver the consulting services and submit your invoice in October, and the company then drags its feet paying the bill, so you don’t actually receive the check until December.
So when do you record that $50,000 as revenue? When you make the sale, when you deliver the service, or when you receive the money?
Under the cash method of accounting, you’d wait until you have the cash in your bank account in December. All through September, October and November, you’d know you have $50,000 coming in soon, but it wouldn’t appear anywhere on your income statement.
Sounds prudent, right? After all, most business owners have stories about clients who delay paying their invoices, or in some cases don’t pay at all. In cash accounting, you only recognize revenue when you have the money in the bank.
But the flipside is that if you incur expenses, those don’t get recorded until you actually pay out the cash. To help you fulfill that new contract, you invest $10,000 in some new computer equipment, for which the vendor offers you a “buy now, pay later” deal.
You’ve spent $10,000 in October, but it doesn’t show up as an expense until you actually cut the check two months later. Not so prudent.
Step 2: What is Accrual Accounting?
The accrual method of accounting aims to record revenue when it’s earned and expenses when they’re incurred, regardless of when the money changes hands.
You still have to be fairly certain of receiving the money before you can record it as revenue. In September, when your sales team lands the contract, you wouldn’t put it down as revenue straight away. You’d generally record it when the product or service has been delivered and an invoice has been sent—so in this case, it would be in October.
How about that computer equipment you bought? Well, under the accrual method, the date the cash changes hands is irrelevant. You record it as an expense when you make the purchase, so in October.
Under this system, you end up with a much more accurate picture of what’s going on in your business. You did the work in October, and the revenue is recorded in October. You bought the computer equipment in October, and the expense shows up in October.
But on the other hand, your accounts are now divorced from the flow of cash, which can create problems, as we’ll see...
Step 3: Pros and Cons of Cash Accounting
Now that you know how each method works, it’s time to look at their pros and cons.
Advantages of Cash Accounting
The main advantage of the cash method is its simplicity. The accrual method can actually get quite complicated when you have more complex transactions than the ones we’ve looked at so far. If you have some bills paid in advance, some in arrears, and others in installments, you can end up shunting money around between several different accounts and scratching your head over exactly when it’s OK to recognize each transaction on the income statement.
With cash accounting, you don’t have to worry about any of that. When the money appears in your account, it’s revenue. When the money leaves your account, it’s an expense. Simple.
Another advantage of the cash method is that it gives an accurate picture of how much cash you have on hand at any particular time. It’s true that you earned that consulting money in October, but the bottom line is that you don’t have the money until December. As we saw in a previous tutorial, managing your cash flow is critical for small businesses, and using cash accounting can help you ensure you always have enough to stay afloat.
Disadvantages of Cash Accounting
As we saw in the introduction, accounting is essentially a way of keeping score for your business. If you rely on the cash method, the score can sometimes be misleading.
The cash method of accounting shows that October was a terrible month for our consulting business, for example. We made no revenue, and incurred a $10,000 expense. December, on the other hand, was an outstanding month—$50,000 in revenue, and no expenses at all.
This is clearly misleading. October was actually the month when we worked hard and earned that $50,000 revenue, and the fact that December was when the check finally arrived in the mail doesn’t make it a great month.
These kinds of errors are easy to spot and adjust for when we’re looking at a single transaction, but when your business has lots of different revenue and expense items, it’s much harder. The larger the gap between when revenue is earned and when it’s received, the bigger the problem.
Essentially, you’re trying to judge your performance based on a set of accounts that reflect the fairly arbitrary fact of when payments were made, and that can create problems. For example, businesses often look at periods when they’re relatively busy and quiet, and allocate staff accordingly. If your revenue is recorded in a different period from when it’s earned, you might end up overstaffed in quiet times and understaffed in busy times.
Step 4: Pros and Cons of Accrual Accounting
Accrual accounting solves some of the problems created by cash accounting, but creates problems of its own. Here’s a summary:
Advantages of Accrual Accounting
Accrual accounting gives a much clearer picture of how profitable the business is, by accurately reflecting when revenue is earned and when expenses are incurred.
This can help you see which months, quarters and years really were successful for you. The picture is not distorted by any delays in payments being made or received.
It also gives a better picture of your overall ‘score’ at any point in time. It’s easier for you to plan, because you’ve accounted for all your revenues and expenses, even if you haven’t received the payments yet.
The accrual method is more effective for handling complicated transactions, because you’re tracking the money in different accounts depending on whether it’s received in advance or expected but not yet received. You’re also accounting for expenses you’ve incurred but haven’t paid yet, helping you avoid overspending.
Disadvantages of Accrual Accounting
Accrual accounting is more complicated than cash accounting. Anyone can track money moving in and out of an account; anticipating transfers that haven’t occurred yet is tougher.
The complexity can also lead to confusion, and even deception. There’s an old saying in business: “Cash doesn’t lie.” Accruals, on the other hand, can be manipulated.
Enron is a famous example of a firm that massaged its accounts by being very aggressive about how quickly it recognized revenue. It signed multiyear gas and electricity contracts, and recorded the full profits on its books the same day. This led to a huge mismatch between how much profit the company was showing and how much money it actually had.
Most companies, of course, don’t go as far as Enron. But when you use the accrual method, you need to remember that you’re recording revenue before you actually receive it. If you’re not careful, you can end up running short of cash, even if you’re business is profitable. You need to track your cash flow separately when using the accrual system, and always consider the possibility that expected revenues don’t come through.
Step 5: Decide Which Method to Use
So which is right for your business: cash or accrual accounting?
Large firms don’t have a choice: they have to go with accrual accounting. If your company has sales of more than $5 million per year or maintains an inventory of items it sells to the public and has gross receipts of more than $1 million per year, you're required to use the accrual method.
For smaller companies, it’s more complicated. Think about what makes the most sense for your own circumstances. If you have a very small firm, the simplicity of cash accounting could make it the better approach, particularly if you generally get paid quite quickly. But as your business gets more complicated, the extra information recorded in the accrual method will start to pay off, especially if there’s often a big gap between when you make a sale and when you get paid.
Also consider your tax situation. It’s not that one method is inherently ‘better’ than the other for tax purposes, but the method you use can affect the tax year in which revenue and expenses are recorded. For particular businesses, choosing one method over the other can give you an advantage.
For example, if you do a lot of business over the holiday season at the end of the year, but don’t receive the payments until January, then the cash method might make sense for you. You get to delay recording the revenue (and paying tax on it) until the following tax year, giving you an extra year to hold that cash and use it for whatever you want. In different situations, the accrual method might be better—it’s about understanding what will help your particular business.
Putting it Together
So now you’ve learned what the difference is between cash and accrual accounting. You’ve seen why it matters, how each system works, and what the pros and cons are.
You’ve seen that the main advantages of the cash method are its simplicity and the way it keeps your accounts tied to the actual money you have on hand. The accrual method, on the other hand, is more complicated, but provides a more accurate picture of how profitable your business is, and when those profits were earned.
So all that remains is for you to decide which one is right for you. Take into account the size and complexity of your business, and your tax situation. Both methods are valid, but you have to pick one or the other, not switch back and forth between them as it suits you. When you’ve decided, you’ll know the right time to record each transaction, and how it affects your business.
As you go forward and use your chosen method, remember that each approach has its limitations. If you’re using cash accounting, remember that the results may not reflect your true performance in each period. And if you’re using accrual accounting, remember that it’s measuring your profits, not your cash, so you’ll also need to keep careful track of your cash flow.
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