Difference between cash and accrual accounting
The difference between cash basis and accrual basis accounting comes down to timing. When do you record revenue or expenses? If you do it when you pay or receive money, it’s cash basis accounting. If you do it when you get a bill or raise an invoice, it’s accrual basis accounting.
Accrual accounting is a far more powerful tool for managing a business, but cash accounting has its uses.
What is cash basis accounting?
Businesses that use cash basis accounting recognize income and expenses only when money changes hands. They don’t count sent invoices as income, or bills as expenses – until they’ve been settled.
Despite the name, cash basis accounting has nothing to do with the form of payment you receive. You can be paid electronically and still do cash accounting. The cash method is most-commonly used by sole proprietors and businesses with no inventory.
Benefits of cash accounting
- It’s simple and shows how much money you have on hand
- You only have to pay tax on money you’ve received, rather than on invoices you’ve issued, which can help cash flow (but not all businesses are allowed to use cash basis accounting for tax so check with the IRS website)
Downsides of cash accounting
- It’s not accurate – it could show you as profitable just because you haven’t paid your bills
- It doesn’t help when you’re making management decisions, as you only have a day-to-day view of finances
What is accrual basis accounting?
Businesses that use accrual accounting recognize income as soon as they raise an invoice for a customer. And when a bill comes in, it’s recognized as an expense even if payment won’t be made for another 30 days.
Benefits of accrual accounting
- You have a much more accurate picture of business performance and finances
- You can make financial decisions with far more confidence
- It can sometimes be easier to pitch for long-term finance
Downsides of accrual accounting
- It’s more work because you have to watch invoices, not just your bank account
- You may have to pay tax on income before the customer has actually paid you –if the customer reneges on the invoice, you can claim the tax back on your next return
Hybrid methods of accounting
Some types of businesses use a hybrid accounting system. They may base big financial decisions and things like loan applications on accrual accounting but use cash-basis accounting to simplify some elements of their tax. There are lots of rules around who can and can’t do this. Speak to an accountant or tax professional to find out what applies to you.
Cash vs accrual vs hybrid accounting
Accrual accounting gives a better indication of business performance because it shows when income and expenses occurred. If you want to see if a particular month was profitable, accrual will tell you. Some businesses like to also use cash basis accounting for certain tax purposes, and to keep tabs on their cash flow. But it’s rare to use cash accounting on its own.
And while it’s true that accrual accounting requires more work, technology can do most of the heavy lifting for you. You can set up accounting software to read your bills and enter the numbers straight into your expenses on an accrual basis. It will also record your invoices as income as you raise them. And if you run a hybrid accounting system, smart software will allow you to switch between cash basis and accrual basis whenever you need.
Xero does not provide accounting, tax, business or legal advice. This guide has been provided for information purposes only. You should consult your own professional advisors for advice directly relating to your business or before taking action in relation to any of the provided content.
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