Cash vs. Accrual Accounting: What’s the Difference?
As if accounting wasn’t frustrating enough, every small business also has to choose between two different methods of keeping their books: cash accounting or accrual accounting. These two terms often cause confusion and dizziness among non-accountants, but here’s the difference in a nutshell.
Cash accounting is essentially simple bookkeeping, and it's the method most commonly used by sole proprietors and mom-and-pop businesses because it’s easy and straightforward. In contrast, accrual accounting requires more work and technical accounting skill, but it's generally required for larger businesses because you can't get truly accurate financials without it. Among accountants, accrual accounting is "real accounting."
To help you understand the differences, here’s a quick snapshot of each method.
- The method used by most sole proprietors and small businesses (i.e. simple bookkeeping).
- Easy and straightforward: You record income when it’s received and expenses when they get paid (checks in = income, checks out = expenses).
- Cash accounting makes intuitive sense, but it doesn’t necessarily provide accurate financials. For example, sales can be disproportionately high one month if you deposit payments from many customers all at once, or expenses can be too low if you don’t enter all your bills.
- More difficult and time-consuming than the cash method, but widely regarded as the more professional and correct method of accounting.
- Provides accurate financial reports because income and expenses are recorded when they occur and can’t be moved between periods.
- Requires significantly more technical accounting skill than the cash method (for example, to correctly record income and expenses each month and handle tricky items like depreciation, interest, and taxes).
Which method is right for you?
If you have a small, cash-based business and you run things primarily by looking at your bank balance every day, then the cash method may be fine for you. However, if your business carries significant inventory and/or has multiple liabilities that need to be recorded each month (like accounts payable, sales tax, commissions, interest payable on loans, etc.), then it's more than likely that the accrual method will be required. In many cases, small businesses start out with the cash method and then transition to accrual accounting (or a hybrid of the two) as they grow and their accounting needs become more sophisticated.
Legal stuff: This information is provided for educational purposes only and does not constitute advice for your specific situation.