Should My Business Use Cash or Accrual Accounting?

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One of the first and most fundamental decisions a business owner makes is whether to use cash basis or accrual basis accounting. The selection determines how revenue and costs are recognized, how financial health is presented and taxes are figured. This blog describes the various approaches, pros and cons of the two methods, and how to determine which one is right for your business.

Understanding the two approaches

Under cash basis accounting, revenue is recorded when received and expenses are recorded when paid. It’s simple, it looks like your cash flow and can give you an accurate sense of exactly how much money is in the bank at any given time. By contrast, accrual basis accounting recognizes revenues when earned and expenses when incurred whether or not the cash has been received or paid. This way income and expense is matched with trading activity producing a more logical view of performance.

The Pros and cons of cash basis accounting

Pros:

• Simplicity: The basics of cash basis accounting are simpler to implement and to understand. There are fewer journal entries and less reconciliation that is required.
• Cash flow visibility: Since revenue is recorded for income and expense when money changes hands, there is a straightforward line of sight to liquidity.
• Reduced administrative load: A cash basis of accounting doesn't require any complex system even smaller businesses with fewer transactions can usually handle it.

Cons:

• Misleading profit: A business could look profitable if its invoices are being paid but it may still have a large amount of unpaid receivables.
• Not as helpful for long-term planning: Because it records income and expense only when cash moves, it can obscure trends and make budgeting more difficult.
• Comparability constraints: Cash basis financial statements are not comparable across companies using accrual accounting.

Advantages and disadvantages of accrual basis accounting

Pros:

• Performance visibility: Revenue and expenditure is nested in the period they're associated with, versus on an accrual basis, enabling greater clarity around profit performance.
• Better for planning and analysis: Accrual accounting makes it easier to forecast income and make strategic decisions because it reflects obligations and receivables.
• Required for some larger businesses: Lenders, investors and regulators often want or require accrual accounting so reports are steady from one period to the next.

Cons:

• Complexity — you have more journal entries, adjustments and reconciliation under accrual accounting than you do cash.
• Cash flow may be opaque: A business could be profitable as measured by accrual accounting and still have trouble with cash because recorded income has yet to come in.
• Potential tax timing issues: Depending on the rules in place for taxes, accrual accounting might recognize taxable income before cash is actually collected.

When each method makes sense

Cash basis accounting is typically best for very small businesses, sole proprietors, and service providers with uncomplicated transaction patterns and immediate payment terms. If your business is local, most transactions are cash or instant card payments and you don’t maintain large quantities of inventory, cash accounting cuts down on the amount of time spent bookkeeping and makes tax filing easier to manage.

Accrual method accounting is generally better for businesses that send out invoices to clients on credit, those with inventory or those who want to become multi-layered beyond just a small business. If you’re invoicing customers, extending terms or want to track payables and receivables for decision-making purposes, accrual accounting presents a more accurate financial position. It’s advantageous, too, should you ever need outside financing or partners that prefer the period-based returns.

For businesses with inventory, they almost always have to use accrual accounting in order to perfectly and properly, at least according to the GAAP rules, match what was spent on the sale of the goods against what were earned from their sales. Many tax authorities have laws that require revenue to be reported based on certain accounting methods (e.g. accrual-based accounting). Check local tax and accounting requirements, some will oblige you to pay according the method used.

Hybrid strategies and handling cash flows

(Some businesses use a mixed model: they keep accurate accruals for internal reporting and long range planning, but they pay attention only to cash while focusing on daily liquidity.) Applying accrual for financial statements and budgeting but maintaining a separate cash flow forecast can reconcile the advantages of both.

However done, active cash flow management is key. Even if the accrual accounting is correct, short-term liquidity can be tight. Keeping cash on hand, negotiating terms with suppliers and customers, and projecting your short term cash flow will help safeguard your business and minimize unpleasant surprises.

The nuts and bolts to determine & do

• Consider the nature of your transactions: Do you invoice customers and offer credit? Do you hold inventory? If so, then accrual accounting is probably a better match.
• Take the reporting requirement into account: Do you require profitability measures based on performance rather than cash timing? Do you intend to apply for funding? If that’s the case, accrual accounting is more aligned with those aims.
• Consider complexity and resources: Cash basis may be less burdensome if bookkeeping is not adequate. But let's be clear here: Scalable growth almost invariably demands it.
• Review tax and legal needs: Many places mandate accrual accounting for specific business sizes or types. Confirm what applies to you.
• Plan the transition: If you’re transitioning to accrual accounting from cash, prepare to record receivables, payables and any deferred revenue. With clean opening balances and clear documentation, the transition is easy.

Conclusion: Match accounting methods to corporate strategy

Just like the previous one, there is no definite solution for cash vs accrual accounting. The right decision is based on the extent of your business, how many transactions you’re processing, reporting requirements and regulations. Small, uncomplicated enterprises are usually the best candidates to take advantage of the simplicity and straightforwardness of cash basis accounting. Businesses that are growing, sell products and services or have outside investors will almost always need the full view provided by accrual accounting.

An appropriate alternative is to prepare financial statements, and develop a plan with accrual accounting while tracking cash activity on another schedule. This mixed approach is conducive to accurate performance determination and daily liquidity management. In the end, opt for the approach that best serves your business needs, enables sound decision-making, and is consistent with all relevant rules.