Cash vs Accrual

Click the image above to read the complete guide

These 2 reporting methods can result in wildly different figures

Let’s start with some definitions…

➡️The CASH Basis

Under the Cash basis of accounting, money IN is treated as income, while money OUT is treated as expenses

Note that while this is generally true, there are some exceptions:

☝️Money IN can represent an expense refund (negative expense), or debt (which is a balance sheet item) to name a few…

✌️Money OUT can represent a sales refund (reduction in sales), or inventory / fixed asset (which are balance sheet items) to name a few…

➡️ The ACCRUAL Basis

Under the Accrual basis of accounting, income is only recognized once it’s EARNED, while expenses are only recorded once they are INCURRED

What does that mean?

Earning income means you delivered your product or service

Incurring expenses means you consumed something that had a cost

…and this is where so many of the adjusting journal entries that are required each month are prepared such as

1️⃣ Prepaids - causing you to amortize certain expenses paid upfront to be split over the the period in which it gets incurred

2️⃣ Deferred Revenue - causing you to amortize income collected / invoiced upfront over the life of the contract

3️⃣ Accruals - causing you to recognize certain expenses in the current period, even if the bill hasn’t been received, or the payment has been made

These are just a tiny few of the many adjusting journal entries required for a month end close

🤔 So which method do I prefer?

Well…that depends a lot on the company

For small companies, the cash basis is great, as it simplifies much of your reporting

At the same time, larger companies almost always opt for the accrual basis of accounting, for the following reasons

1️⃣ GAAP Requires Accrual

While the IRS may allow companies up to a certain size to report under either method, GAAP requires you to reconcile under the accrual method.

That can be especially relevant for the 2nd reason:

2️⃣ Investors like to see what’s really happening

When you have outside investors, it’s common for them to want to see your financial statements under the accrual basis

Why?

Because the accrual basis explains what’s really happening in the business, allowing you to make better sense on key KPIs & margins, and to forecast the future

So in short:

◾SMALL BUSINESSES without a heavy amount of outside capital can benefit from the SIMPLICITY of the CASH BASIS of accounting

◾ LARGER BUSINESSES with a larger amount of outside capital are often required to record under the ACCRUAL basis

That’s my take on the Cash vs Accrual basis of accounting…but there’s much more to it