Accrual vs. Cash Basis Accounting

by | May 18, 2022 | Accounting

Accounting is often referred to as the “language of business,” and like many languages, learning the nuances of accounting can feel complicated. One of the first things to learn about accounting is that businesses can choose between a cash method and an accrual method of accounting. In this article, we will explain accrual vs. cash accounting and their basics.

What is Cash Method Accounting?

Cash method accounting is likely what you are familiar with if you are new to accounting. Cash basis transactions take place when actual cash changes hands. For example, if you clean a client’s home, once you receive cash for your services you can add the cash as revenue.

Similarly, until you pay cash for services, the transactions will not be included as expenses. Cash method accounting is straightforward to understand and is one of the reasons some businesses choose the cash method when deciding accrual vs cash accounting.

What Are Other Benefits of Using the Cash Method?

Another benefit of the cash method is for tax purposes. Companies who choose the accrual method when determining accrual vs. cash accounting must also keep a second set of “tax books” based on the cash method. This is because the cash method is required by the IRS to properly calculate a company’s tax bill.

An example can help clarify. Suppose you own a rental property. Your tenant decides to pay for the year 2023 in cash on December 31st of 2022. This payment must be included in your income for 2022, and you will have to pay tax on it.

What Is Accrual Accounting?

The biggest difference when looking at the accrual vs. cash method of accounting is the way income and expenses are recorded. Unlike the cash method, the accrual method requires that income is recognized as it is earned, and expenses recorded as they are incurred. This is a bit abstract so let’s look at an example.

Income

Suppose you own a service-based business that provides painting services. You charge $40 per hour, and each job generally takes 8 hours, or one day, to complete. If you used the cash method of accounting, you would not record revenue until you receive a cash payment from your customer.

However, the accrual method requires you to record revenue once the job is completed. In this case, your service-based business will record $320 of revenue at the job’s completion as an account receivable.

You may be wondering what happens when your customer sends cash for payment. After all, you have already recorded the revenue, so how can you record the cash payment without doubling your revenue?

In this case, the value of your accounts receivable will be reduced by $320 and the value of your cash account will increase by $320. Because both accounts receivable and cash are assets, the net value of your assets will not change.

Also, no revenue accounts are changed when this occurs, so your net revenue remains the same.

Expenses

Accrual accounting uses a similar concept for recording expenses. Instead of recording them when cash leaves your service-based business, they are recorded as they are incurred.

For example, suppose you receive a $100 utility bill on March 31st. You pay the bill on April 15th. Cash accounting would record this expense on April 15th, when the money leaves your account.

However, accrual accounting requires you to record the utility expense on March 31st, when the invoice was received. Because you have already incurred the utility expense, you owe the utility company $100. This is recorded as a liability on your balance sheet until the cash leaves your account.

Benefits of Accrual Accounting

Although it does take time to get used to the concepts of accrual accounting, it has
benefits when comparing the accrual vs. cash method.

The major advantage is that accrual accounting gives a much more accurate picture of your service-based business’s financial health. Large cash payments (such as the rental payment previously discussed) can skew the income side of your cash books.

Similarly, large expenses, such as new equipment, can skew the expense portion of your cash books if using the cash method.

Accrual accounting would require that the large cash payment only be recorded as income as it is earned, and the large expenses only be recorded as expenses as they are incurred (depreciation).

This is especially useful when forecasting and budgeting are involved. A large cash payment recorded as income may give the impression your service-based business has earned more cash than it actually has, which may lead to the belief that more expenditures are affordable.

Because accrual accounting records income and expenses as they occur, your monthly financial statements will be much more accurate.

 

We hope this article has helped explain accrual vs. cash accounting. The concepts can take some getting used to, but both methods can be useful.

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