What is an accounting method of recording income when it is actually earned and expenses when they actually occur?

The accrual basis of accounting is a method of recording financial transactions in which revenue is recognized when it is earned and expenses are recognized when they are incurred, regardless of when the cash is actually received or paid. Under the accrual basis of accounting, revenue and expenses are matched and recorded in the period in which they occur, rather than in the period in which the cash is exchanged. This results in a more accurate picture of a company's financial performance and position.

Why is it Different from Cash Basis Accounting?

Cash basis accounting is the recording of income when it is received and expenses when they are paid. It is the simplest form of accounting and is used by most small businesses. It does not provide a complete picture of a company's financial health, as it does not account for receivables (money that is owed to the company) or payables (money the company owes).

Income statement:

Cash basis accounting would record $10,000 in revenue when the cash is received, and would record $3,000 in expenses when the cash is paid. This would give a net income of $7,000.

Accrual accounting would record $10,000 in revenue when the invoice is issued, and would record $3,000 in expenses when the bill is paid. This would give a net income of $7,000.

Why is Accrual Basis Accounting Better than Cash Basis Accounting?

Accrual basis accounting is a more accurate way of accounting for a company's financial position and performance than cash basis accounting. Under accrual basis accounting, revenue is recognised when it is earned, not when it is received in cash. Similarly, expenses are recognised when they are incurred, not when they are paid in cash. This means that the company's financial position and performance are more accurately reflected in its financial statements.

Cash basis accounting is a simpler way of accounting for a company's financial position and performance than accrual basis accounting. Under cash basis accounting, revenue is recognised when it is received in cash, and expenses are recognised when they are paid in cash. This means that the company's financial position and performance are more accurately reflected in its financial statements. However, because cash basis accounting does not take into account revenue that has been earned but not yet received, and expenses that have been incurred but not yet paid, it gives a less accurate picture of the company's financial position and performance.

What are the Advantages of Accrual Basis Accounting?

The advantages of accrual basis accounting are:

1. It reflects the true financial position of a company because it records revenues when they are earned and expenses when they are incurred, regardless of when the cash is actually received or paid.

2. It provides a more accurate picture of a company's financial performance, as it takes into account the timing of inflows and outflows of cash.

3. It is more useful for financial analysis and decision-making, as it allows for comparisons of companies' performance over time and across industries.

4. It is compliant with Generally Accepted Accounting Principles (GAAP), which are the accepted guidelines for financial reporting in the United States.

What are the Disadvantages of Accrual Basis Accounting?

The main disadvantage of accrual basis accounting is that it can be difficult to determine a company's true financial position because accrual accounting principles recognize revenue and expenses when they are earned or incurred, rather than when cash is actually received or paid. This can lead to inaccurate financial statements if a company's cash flow is not stable. For example, a company that sells a product on credit might report higher revenue and net income than it would if it sold the product for cash. This is because the company would recognize the revenue from the sale as soon as it shipped the product, even though it might not receive the cash from the sale until later.

What are the Requirements for Having an Accrual Basis Accounting System?

An accrual basis accounting system records revenue when it is earned and expenses when they are incurred, regardless of when the cash is received or paid. This system is more accurate than a cash basis accounting system, which records revenue when it is received and expenses when they are paid. To have an accrual basis accounting system, a company must track its revenue and expenses on an accrual basis. This means recording revenue when it is earned and expenses when they are incurred, not when the cash is received or paid. The company must also have a system for tracking account receivables (amounts owed to the company) and account payables (amounts the company owes).

For small companies that do business primarily through cash transactions and do not maintain large inventories of products, the cash accounting method can be a convenient and reliable way to keep tabs on revenue and expenses without the need for a great deal of bookkeeping.

However, for the most accurate and updated accounting view of your financial health, accrual accounting might be the better choice. There are also some other factors to keep in mind.

The complexity of your business

Depending on your industry and the complexity of your books, one accounting method may be more sustainable than the other. For example, a business with multiple accounts, hundreds of employees, and various LLCs will probably want to stay away from cash basis accounting because it won’t give the company the big picture view it’s looking for when it comes to financials on the income statement, balance sheet or cash flow statement. 

Sales revenue 

Another reason to choose one over the other would be based on your sales revenue. According to GAAP, if you exceed $25 million in annual revenue, then you are required to use the accrual method. For many small businesses, this isn’t an issue at the moment but maybe in the future, so it’s something to keep in mind. 

Publicly Traded 

Having a publicly-traded company or one that may go public is another stipulation of the GAAP guidelines. Publicly traded companies have a duty to report an accurate view of their financial well-being to shareholders. The best method for this is the accrual system of accounting. 

Moving forward 

Before moving along through your small business accounting checklist, understanding which accounting method to use is, without a doubt, an imperative decision for your business. That’s not to say it can’t be changed later—only that it’s harder to switch once you get comfortable with one way or the other. Accounting software and tools like QuickBooks Live can help with either method, with virtual accountants available to help you every step of the way. 

Bottom line, whether you choose cash or accrual accounting, remember to understand both options and stay within compliance with GAAP for your state.

Companies can choose between two primary accounting methods: cash basis and accrual basis. The adage “timing is everything” captures the biggest difference between them. Cash accounting reflects business transactions on a company’s financial statements when the cash flows into or out of the business. Accrual accounting recognizes revenue when it’s earned and expenses when they’re incurred, regardless of when money actually changes hands. The difference in timing ripples through the company’s income statements and balance sheet, and subsequently affects its tax liability.

Each method has advantages and disadvantages. Notably, the cash method is more straightforward. But only the accrual basis is accepted by Generally Accepted Accounting Principles (GAAP), which is a set of rules established by the Financial Accounting Standards Board (FASB). Depending on a company’s circumstances, it may be easy to choose which method is the best fit.

Cash-Basis vs. Accrual-Basis Accounting: What’s the Difference?

Cash-basis accounting is the easier of the two methods because, as its name implies, all bookkeeping simply follows the cash. The company records revenue when customer payments are received. It records expenses when it makes payments to suppliers. Taxes are calculated on the resulting net income.

Under the cash basis, there is no need to account for customer sales made on credit (i.e. accounts receivable) until they pay. Similarly, no bookkeeping is required for purchases from vendors on credit (i.e. accounts payable or accrued expenses) until the company pays for them. Cash-basis accounting is a simple way to easily see a company’s cash status.

Example: The following example illustrates the timing and simplicity of cash accounting for a small business. It also shows the swings in taxable income that can result from using this method.

ITCHY Inc., a tree-spraying company, provides a monthly insection-prevention spraying service for its customers. A customer signs an annual contract and pays $1,200 upfront on June 1, 2020. ITCHY pays its chemical supplier $50 for each tank of insecticide when it picks up the tank on the morning of each monthly spray.

• ITCHY records all $1,200 of revenue in June.
• ITCHY records $50 in expenses in each month, June-May.
• ITCHY’s income/(loss) for each of the 12 months is shown below.
• ITCHY pays income taxes on $850 of income for 2020 and shows a loss for 2021.

Accrual-basis accounting combines two important accounting principles: the matching principle and the revenue recognition principle. Under these principles, revenue is recognized when it is earned, and expenses are reflected in the period that best matches the revenue they help create. Accrual accounting bookkeeping is uncoupled from when the money involved actually changes hands, thereby smoothing the impact of timing and yielding a more accurate overall picture of a business’ operations.

Example: Using the same example above, the following chart shows ITCHY’s financial results using the accrual method.

• ITCHY evenly prorates the $1,200 cash as $100 of revenue for each of the obligated 12 sprays.
• ITCHY records $50 in expenses in each month, June-May.
• ITCHY’s income/(loss) is shown for each of the 12 months.
• ITCHY pays income taxes on $350 of income for 2020 and $250 for 2021.

Key Differences, Advantages and Disadvantages

The key difference between the cash and accrual methods relates to the timing of revenue and expenses: When they’re received/paid and when they’re earned/incurred.

Many businesses prefer to use cash accounting because the financial statements closely reflect their cash position, which is especially important for small business owners. The simplicity also makes bookkeeping easier and cheaper. And under cash-basis accounting a business doesn’t have to pay taxes on cash it hasn’t collected.

The main disadvantage of the cash basis is that financial results in any given period may look distorted. Those distortions can make planning and forecasting complicated. Also, cash accounting is not accepted by GAAP, and any resulting financial statements are considered insufficient by most lenders and are prohibited for publicly traded companies.

The accrual basis of accounting is the gold standard because it gives a more accurate representation of a company’s finances. With accrual accounting, businesses can more easily keep track of credit transactions using an accounts receivable system, which shows the full transaction history of each customer. An accounts payable system shows the transaction history between your company and a vendor or supplier. GAAP compliant accrual accounting is required for companies of a certain size, with certain debt covenants or that are publicly traded.

A disadvantage of accrual accounting is the additional bookkeeping. Rather than just look at cash coming in and out, businesses using accrual accounting monitor receivables, prepaid expenses, accounts payable and other accrued liabilities. It also requires more frequent closing of the company’s books. Another disadvantage is that the accrual basis might obscure short term cash flow issues in a company that looks profitable on paper.

A summary of key differences between the two methods, as well as their advantages and disadvantages are in the chart below.

What are Recording Transactions?

For the most accurate and useful financial statements, accountants record transactions using double entry bookkeeping. Each transaction is entered in two accounts: debits and credits. These two entries are equal and opposite. Listing everything twice can help companies catch errors and prevent fraud, and it can be beneficial for auditing. Both cash- and accrual-basis accounting can use double entry bookkeeping. In accrual accounting, the five types of accounts—revenue, expense, asset, liability, and equity—are used to categorize transactions.

The single-entry system looks a little more like a personal bank account where amounts are credited or debited in one table or ledger. It can only be used with cash-basis accounting, not accrual accounting.

Choosing Between Cash- and Accrual-Basis Accounting

For all publicly traded companies and most businesses with investors or lenders, there is no choice in accounting method. These companies must comply with GAAP and use the accrual basis of accounting for both financial reporting and tax purposes.

Businesses with less than $25 million in gross receipts do have a choice. For details on how to apply the gross receipt test, the IRS guidelines on acceptable accounting methods and how to change your accounting method, refer to IRS Publication 538.

Cash-basis accounting might be right for your business if you rely on cash payments for revenue and expenses. Conversely, businesses that extend credit to customers or use credit with their suppliers tend to find that accrual accounting gives a better picture of overall financial health. Businesses that hold large amounts of inventory also benefit from accrual accounting. In general, the greater the lag in conversion to cash from sales, the stronger the argument for accrual-based accounting.

Effects of Cash and Accrual Accounting on Cash Flow, Taxes and Policy

The method of accounting, cash or accrual, can significantly impact a company’s cash flow and tax liabilities, as illustrated above. It can also impact the policies and processes that a business needs to adopt. A few examples include:

• Companies that use the cash method of accounting won’t have accounts receivable ledgers and need processes to stay on top of outstanding customer accounts.
• Companies usually use the cash method of accounting because they deal mostly with cash transactions. They need safeguards over receipts and disbursements of cash so it’s not lost or stolen.
• Companies that use the accrual method of accounting implement procedures to reconcile bank accounts and keep tabs on short term cash flow.
• Start-ups and entrepreneurs using cash accounting for simplicity often need to change their accounting policies in later stages as they begin to invest in long-term assets or contemplate initial public offerings.

Using Accounting Software to Streamline Your Accounting Process Practice

Accounting software can automate functions, make workflows and processes more efficient, reduce errors and lower staff costs with both cash- and accrual-basis accounting. And those benefits are especially useful for the more complex accrual method. Recurring journal entries, bank reconciliations and balancing accounts—all key components of accrual accounting—are included in the core functionality of most accounting software.