What are the differences between cash and accrual basis accounting provide an example of each?

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4 Min. Read

March 28, 2019

Accrual basis and cash basis are two methods of accounting used to record transactions.

The key difference between the two methods is the timing in which the transaction is recorded. Over time, the results of the two methods are approximately the same.

Here is a brief overview of both methods:

Accrual Basis: The transaction and revenue are recorded when earned and expenses are recorded when consumed.

Cash Basis: The transaction and revenue are recorded when cash is received from customers. Expenses are recorded when cash is paid to suppliers and employees.

As per the IRS regulations, the cash basis method is only available if a company has no more than $5 million in sales per year. Cash basis is the easiest accounting method for recording transactions because no complex accounting transaction such as accrual and deferrals are needed. This method is widely used in small businesses because it is so easy to use. However, the random timing of cash receipts and expenditures means that results reported can vary between unusually high and low profits

Although the IRS requires (and can only audit) all companies with sales exceeding over $5 million dollars, there are other reasons larger companies use the accrual basis method to record their transactions. Under accrual accounting, financial results of a business are more likely to match revenues and expenses in the same reporting period, so that the true profitability of a business can be recognized. Unless a statement of cash flow is included in the company’s financial statements, this approach does not reveal the company’s ability to generate cash.

This article will also include information on:

What Is the Main Difference Between Cash and Accrual Accounting?

What Is Better Cash or Accrual Accounting?

NOTE: FreshBooks Support team members are not certified income tax or accounting professionals and cannot provide advice in these areas, outside of supporting questions about FreshBooks. If you need income tax advice please contact an accountant in your area.

What Is the Main Difference Between Cash and Accrual Accounting?

The main difference between accrual and cash basis accounting is the timing of when revenue and expenses are recorded and recognized. Cash basis method is more immediate in recognizing revenue and expenses, while the accrual basis method of accounting focuses on anticipated revenue and expenses.

Here are some examples that apply these concepts:

Revenue Recognition

A company sells $20,000 of product to a customer in August. The customer pays that invoice in September. With the cash basis method, the company recognizes the sale in September, when cash is received. Whereas with the accrual basis accounting, the company recognizes the sale in August, when it is issued the invoice.

Expense Recognition

A company buys $700 of office supplies in March, which it pays for in April. With the cash basis method, the company recognizes the purchase in April, when it pays the bill. Whereas with the accrual basis accounting, the company recognizes the purchase in March, when it received the supplier invoice.

What Is Better Cash or Accrual Accounting?

Both accrual and cash basis accounting methods have their advantages and disadvantages but neither shows the full picture about a company’s financial health. Although, accrual method is the most commonly used by companies, especially publicly traded companies. A reason for the accrual basis method of accounting popularity is that it levels out earnings overtime since it records all revenue and expenses as they’re generated instead of being recorded sporadically like they are under the cash basis method.

Here are the advantages and disadvantages of both accounting methods.

Cash Basis Accounting Method

Accrual Basis Accounting Method

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Starting your business is reason enough for stress. On top of that, dealing with your finances and accounting on your own can only add to the headache. At KPMG Spark, we want to help you simplify the process and we’ve put this guide together to help you better understand your accounting. Here, we’ll lay out the differences between the cash and accrual accounting methods and how to choose which is best for your business.

Cash and accrual accounting

Cash basis accounting and accrual basis accounting are two main types of accounting that businesses employ to keep track of their finances and for tax purposes. While they both have their pros and cons, depending on factors within a business (like inventory and the size thereof) you may be inclined or required to use a particular accounting method. To put it simply, cash accounting generally recognizes your revenue and expenses exactly when the cash enters or leaves your bank account while accrual accounting generally recognizes revenues and expenses when they are earned or incurred. Here, we will dive into the differences between the two and how you can decide which one to use for your business.

Cash basis accounting

Cash basis accounting is used largely by small businesses that need to keep track of their cash flow at all times. It tends to be easier as there generally is less to track; many small businesses and a large portion of KPMG Spark clients use this method because of its simplicity. Cash basis accounting generally recognizes all revenue as it is received and all expenses when the money is spent. This means that whenever you look at your bank balance, you know exactly what resources are at your disposal. It also means that your revenue generally will not be subject to tax until the cash is in the bank (although there is also a concept of ‘constructive receipt’ for certain amounts available upon demand). While simple and easy to maintain, the cash basis of accounting does not always show an accurate image of the true financial state of a business.

For example, if your company appears to be cash-rich but has large amounts of account payables and has yet to pay them, your financial standing reflected in your bank accounts may look inappropriately good. In this case, investors might think your company is about to make a profit and continue growing but in reality, it may be losing money because of the unpaid accounts payable.

Accrual basis accounting

On the other hand, accrual accounting recognizes revenue when it’s earned and expenses when they are billed (or in some cases as earned by the counterparty). This type of accounting is more popular among larger businesses but is typically more complicated and, at times, more labor-intensive. An example of accrual accounting would be if another entity or person owes your company money; if you have already sent an invoice to your customer, then you would record the amount owed by your customer as revenue, even if the customer hasn’t yet paid you. This method is mostly used by larger businesses and is even required for businesses with average revenue exceeding 26 million dollars a year. Accrual accounting tends to provide a more realistic financial view of a business over the long term and is especially helpful for companies with large amounts of inventory.

Even though the accrual method tends to be more popular among large businesses, it does have its drawbacks. Unlike the cash basis method, the accrual accounting method does not actively track your cash flow. This can be very dangerous for businesses with a cash shortage in the short term as they can end up spending money they do not actually have because they appear to be profitable in the long term – stated differently, they have reported lots of revenue, but they haven’t been paid, so there is no cash in the bank. While using the accrual method, it is imperative to have someone tracking the incoming revenue and outgoing expenses to understand the actual cash position of the business.

Payroll accrual

An aspect of accrual accounting that highlights its complexity is payroll. Assume a company pays its employees on the fifth of the month for the prior month’s work. Because your employees have already earned their pay for the month, under the accrual method you would need to account for the pay you owe to them at the end of the month, days before they are actually paid – the amount owed is an accrued payroll liability for your business. If you expand this concept beyond payroll – for example to utilities, rents, service contracts, leases, loans, etc. -  this begins to create a long list of expenses that need to be recorded as accrued expenses (or payables). This illustrates why accrual accounting is more labor-intensive and more expensive.

Profit

While tracking expenses and trying to determine net profit, the two accounting methods, cash v accrual, will yield different results. Under the circumstances listed below, we will assess the profit of a particular month.