Cash vs. Accrual Accounting: A Comprehensive Guide for Businesses

Choosing between cash basis and accrual accounting might seem like a mundane decision, but it can have a big impact on your business’s financial health.

At its core, this choice boils down to how you record income and expenses. Cash basis accounting might seem straightforward and easy to handle on your own, but it misses the mark in many ways. Conversely, if you go with accrual accounting, you might need to bring in experts to handle your finances.

But don’t let the complexity scare you off. The right accounting method for your business depends on various factors, including your industry, size, and financial goals.

So, regardless of whether you’re at a small company that needs simplicity or a larger enterprise that needs detailed financial insights, you need to know the differences between these two — especially if you want to make an informed decision.

Key Differences Between Cash vs. Accrual Accounting

Cash and accrual accounting have a simple difference. Accrual accounting records revenue and expenses when a transaction happens, like when you sign a contract. On the flip side, the cash method of accounting only records income and expenses when money actually lands in your account.

But there’s more to the two than this simple distinction. Let’s dive into the details to help you decide which method is best for your business.

What is Cash Basis Accounting?

In cash basis accounting, you record revenue and expenses only when you receive or pay out cash, rather than when you earn or incur them. Simply put, it focuses solely on the actual movement of money in and out of your business, ignoring other essential financial aspects.

Now, you might be wondering: why bother with cash basis accounting? Wouldn’t every company go with accrual? Not necessarily. Small businesses and sole proprietors with simple transactions often use cash basis accounting, especially if they deal primarily with cash — it just makes sense in those cases.

But, the cash basis method also doesn’t give you the whole picture. It also doesn’t adhere to the Generally Accepted Accounting Principles (GAAP), nor does it comply with the International Financial Reporting Standards (IFRS).

For instance, with cash basis accounting, a retailer’s books might seem very profitable in Q4 due to holiday shopping sprees. However, come Q1 of the next year, they could seem unprofitable as consumer spending slows down after the holidays. As you might guess, this doesn’t give you a holistic picture of the business’s financial performance.

All this to say, cash basis accounting has its gaps.

That said, one of the upsides of cash basis accounting is that you don’t pay taxes on revenue until the money is actually in your bank. Since you only record transactions when cash changes hands (or banks), it can actually help you manage your tax obligations more effectively.

For example, let’s say you provide a service in September, but your client doesn’t pay you until January of the following year. With cash basis accounting, you record that income in January, which means you don’t have to pay taxes on it until the next tax year.

Obviously, this can be great for managing your cash flow and keeping your tax bill low for the current year. Just remember, while this gives you a temporary tax benefit, you’ll still need to recognize and pay taxes on that income when you receive the payment.

What is Accrual Accounting?

On the flip side, with the accrual method, you record revenue and costs when they are earned or incurred, no matter when the cash actually changes hands. So, this gives you a more accurate view of your company’s financial position and performance over time.

As your business grows, especially if you get external funding or go public, accrual accounting is just more practical. That’s because while cash basis accounting offers a clear snapshot of your financial health at any given moment, accrual accounting offers a more comprehensive view.

And there are other benefits, too.

Let’s walk through an example. Imagine your company receives an invoice for office supplies totaling $1,500. With cash basis accounting, you wouldn’t record this expense until you actually pay the invoice. However, with accrual based accounting, you’d record the $1,500 expense as soon as you receive the invoice. And from a financial perspective you’d match your revenue and expenses to the appropriate year.

As a result, you’ll keep your books more balanced. As for revenue — even if money comes in, until services are provided, you’d consider that to be unearned revenue under accrual accounting.

For tax purposes, the accrual method of accounting might actually speed up your tax liabilities because you might owe taxes even if the money isn’t in your account yet. Of course, this depends on your net income.

Choosing the Right Accounting Method for Your Business

When it comes to managing your business finances, choosing the right accounting method is crucial. At its core, accounting is about recording and reporting financial transactions. However, the method you use — cash or accrual — can significantly impact how you view your company’s financial health and make strategic decisions.

We’ve covered the essentials already. At its simplest, cash basis accounting means recording transactions when cash actually changes hands. This might bring up an image of you counting bills at the end of the day, but as you know, this approach is more nuanced than that.

Cash basis accounting is often favored by small businesses and startups for its ease. Income is reported when it’s received, and expenses are recorded when they’re paid. Of course, this method provides a clear, immediate picture of cash flow, making it easier to track liquidity.

But as you know, there are times when cash basis accounting may fall short. For example, if you’ve delivered a service but haven’t yet been paid, your revenue won’t show up until the payment is received. This can make it challenging to match income with related expenses, potentially giving you an incomplete picture of profitability.

On the other hand, you’ll log income when you earned it and costs as they happen in accrual accounting, regardless of when cash comes in. This might seem more complex, but it’s a more realistic (and accurate) reflection of your company’s financial state.

However, the complexity of accrual accounting means it needs a more reliable bookkeeping and accounting system (and professionals), plus it can be less intuitive when you’re tracking cash flow.

When to Switch Accounting Methods

So, when does it make sense to switch from cash to accrual accounting? Well, that depends on your business needs and growth stage. Here are a few scenarios:

As your business grows, accrual accounting can provide a clearer picture of financial health, helping with strategic planning and attracting investors.

If you’re managing significant inventory, accrual accounting can more accurately match income with the cost of goods sold, offering better insights into profitability.

When you offer credit to customers, accrual accounting ensures revenue is recognized when earned, giving a more accurate picture of sales performance.

Certain regulatory thresholds, such as revenue limits, might require switching to accrual accounting to comply with GAAP requirements.

For example, if your business is a corporation (excluding S corp) or a partnership with a corporate partner, and you’ve averaged over $25 million in gross receipts annually for the past three years, the Internal Revenue Services (IRS) requires you to use accrual accounting. Additionally, if your business is classified as a tax shelter, you’ll need to follow accrual accounting.

For smaller businesses, particularly those with annual gross revenue under $25 million and without complex inventory needs, cash basis accounting might be the best fit due to its simplicity. However, if you’re dealing with substantial inventories, accrual accounting might give you more accurate financial insights.

How Mosaic Supports Cash Basis Accounting and Accrual Accounting

If you haven’t heard of Mosaic, here’s a quick introduction. Mosaic is a strategic finance platform designed to simplify the lives of finance teams, whether you’re part of a small company or a large enterprise.

Mosaic seamlessly integrates with your core business systems — ERP, CRM, HRIS, billing, data warehouse, and flat file uploads — pulling essential data into a single source of truth. Moreover, Mosaic offers over 150 ready-to-use financial metrics that are updated in real-time. Creating custom metrics is also super easy with Metric Builder.

With data pulled straight from the source, you can trust its accuracy. Plus, you can present this information in visually appealing, easy-to-understand financial dashboards, making it simple to share your company’s financial story with key stakeholders in a language they’ll understand.

Using Mosaic for Direct and Indirect Cash Flow

When it comes to picking a method of accounting, understanding the differences between direct and indirect cash flow is pretty much a must. If you’re using cash basis accounting, the direct method is your go-to because you can see actual cash inflows and outflows. But keeping track of this can get really time consuming.

On the flip side, accrual basis accounting typically leans on the indirect method. Essentially, this begins with the net income and adjusts non-cash transactions with changes in the balance sheet to reconcile cash flow. It’s a bit more complex, as you’ve probably figured out by now.

But here’s where Mosaic steps in to make life easier.

Mosaic can handle both methods seamlessly. We get it — if you’re using accrual accounting, dealing with direct cash flow can be a real pain. That’s where Mosaic’s integration from your ERP comes into play. Mosaic pulls in all the granular data you need and makes direct cash flow calculations straightforward and hassle-free.

The bottom line? Whether you’re sticking with cash basis accounting or navigating the complexities of accrual accounting, Mosaic has got you covered. But hey, we get it if you have to see it to believe it.

See Mosaic in action. Request a personalized demo.