Cash vs Accrual Accounting

The difference between cash and accrual-based accounting is when you recognize your revenue and expenses. Cash-based accounting recognizes revenue and expenses when cash is received or paid. This is compared to accrual-based accounting, which recognizes the funds when the invoice is created or the bill is received.

An example of cash-based accounting is recognizing revenue when you receive payment from your customers, not when you invoice them. Similarly, expenses would be recognized when you pay a vendor, not when the bill is received. Businesses that start out using a checkbook-centric method of recording cash are using a cash-based system.

For some small businesses, a hybrid system works best, and it looks something like this:

• Revenue is recorded when invoiced so that you can track receivables.
• Expenses are recorded when bills are paid.

In effect, you are using accrual-based accounting for revenue recognition (because you need to track sales and customer accounts), and you use cash-based accounting for recognizing expenses (when you pay a vendor).

Ultimately, your accountant will make the necessary adjustments to prepare and file your tax returns, converting your records from accrual to cash-basis.. They will take your hybrid system and adjust it to reflect either cash-based or accrual-based numbers. For cash-based, they adjust your ‘accrued’ balances to zero as if the transactions never happened since payment has not yet been received. If you have an Accounts Receivable balance reflecting $2,500 in sales you’ve not been paid for, your accountant will make an adjustment to reduce Accounts Receivable by $2,500 and reduce Sales by the same amount. In cash-based accounting, technically, those sales aren’t recorded or reported on until cash changes hands. The same idea applies to Accounts Payable (by adjusting the amounts posted to each liability or expense, for example).

For businesses that use accrual-based accounting, their system looks like this:

• An invoice is generated for goods and services sold, increasing sales and creating an amount due (accounts receivable).
• When the customer pays you, another transaction is recorded, increasing your cash balance and reducing your previously recorded receivable to zero.

The same idea works when recording expenses: a bill is received and recorded by tracking what expense (cost of goods sold or another expense) was incurred and creating an accounts payable record. When you pay your vendor, another transaction is recorded, which reduces cash and reduces your payable amount to the vendor.

Different types of businesses lean toward operating as a cash or an accrual-based business. You could run a lawn mowing business and accept payment upon completing a job (cash-based). Or, you can be a large landscaping company that bills customers monthly and tracks payments as they come in (accrual).

Many could operate as a hybrid – track sales as cash is received (cash-based), but still have payables (accruing amounts you owe).

You may operate your business as an accrual-based business, tracking full receivables and payables, but your accountant may still file your income taxes as a cash-based business.

The best bet is to talk to your accountant to see what options are best for your business and deliver the best tax implications.