What is accrual accounting?

Accrual accounting records revenues and expenses when transactions occur, regardless of when cash related to those transactions is received or disbursed.

In other words, revenue is recorded when it is earned. This means that revenue is recognized when a product or service is delivered to a customer, even if payment is expected in the future. Similarly, expenses for goods and services are recorded before any cash disbursement.

The accrual method can provide a more accurate view of a company’s financial health by including accounts payable and accounts receivable. Large companies and publicly-traded entities commonly use it because it provides a comprehensive and long-term perspective on a company’s profitability.

Advantages of accrual accounting

  1. More accurate financial picture: Accrual accounting provides a comprehensive understanding of a company’s financial health by accounting for all revenues and expenses as they are generated.
  2. GAAP compliance: The accrual method adheres to the Generally Accepted Accounting Principles (GAAP) issued by the Financial Accounting Standards Board (FASB), making it the required method for many businesses.
  3. Smoother earnings over time: By accounting for revenues and expenses as they occur, the accrual method helps to smooth out earnings over time, providing a more stable view of profitability.

Disadvantages of accrual accounting

  1. Increased complexity: Accrual accounting can be more intricate, requiring tracking items such as unearned revenue and prepaid expenses.
  2. Additional staffing requirements: Due to its complexity, accrual accounting may necessitate hiring additional staff members or outsourcing bookkeeping tasks.
  3. Limited cash flow tracking: The accrual method does not directly track cash flow, which could lead to short-term cash shortages.

What is cash basis accounting?

On the other hand, cash basis accounting is a more straightforward accounting method that records revenue and expenses only when cash is received or disbursed.

Under the cash basis method, revenue is reported on the income statement only when cash is received, and expenses are recorded only when money is paid out. This method provides a snapshot of a company’s cash flow, making it easier to track and manage.

This approach is typically used by small businesses, sole proprietors, and individuals managing personal finances.

Advantages of cash basis accounting

  1. Simplicity: The cash basis method is straightforward, only accounting for cash paid or received.
  2. Ease of cash flow tracking: Cash basis accounting facilitates tracking a company’s cash flow, providing a clear view of available funds.
  3. Lower staffing requirements: Due to its simplicity, cash basis accounting may not require additional staff or outsourcing, reducing related expenses.

Disadvantages of cash basis accounting

  1. Inaccurate financial picture: The cash basis method may overstate the health of a cash-rich company, as it does not account for accounts payable or other liabilities.
  2. Not GAAP compliant: Cash basis accounting does not comply with GAAP standards, making it unsuitable for many larger businesses and publicly-traded entities.
  3. Limited long-term financial insights: Since cash basis accounting focuses on immediate cash flow, it may not provide adequate insights into the long-term financial health of a business.

Key differences between accrual and cash basis accounting

The primary distinction between accrual and cash basis accounting lies in the timing of revenue and expense recognition. While the cash method recognizes revenue and expenses immediately when cash is received or paid, the accrual method focuses on anticipated revenue and expenses.

To put it more simply, the cash method often allows you to defer the recognition of income, whereas the accrual method often allows you to accelerate it.

For example, if you purchase inventory on January 1 and it is delivered the same day, but you will only pay for the goods on April 1, you would wait until April 1 to record the purchase if using the cash method. On the other hand, if using the accrual method, you would record the purchase on January 1, when the goods are delivered.

The cash method can seem more straightforward and intuitive than the accrual method, but it needs to provide more accurate information. With the cash method, you don’t have any information about the money you are owed or owe until it is received or paid. With the accrual method, you can see the complete picture of your financial position, as this method records all transactions when they occur, regardless of when the cash is exchanged.

Tax law changes

It’s important to note that 2017’s Tax Cuts and Jobs Act (TCJA) implemented procedural and regulatory changes, which led to complex alterations in accounting methods that can be challenging to comprehend.

For example, the TCJA brought significant changes to the eligibility criteria for using the cash method of accounting.

Previously limited to smaller businesses and specific revenue thresholds, the Act expanded the threshold to an impressive $25 million in 2017, with adjustments for inflation in subsequent years. This means entities with average annual gross receipts below the threshold may opt for the cash method.

However, exceptions apply, such as limitations for partnerships with losses allocated to limited partners and restrictions on tax shelters.

The TCJA also grants exemptions from specific accounting rules for inventories, cost capitalization, and long-term contracts, providing additional flexibility for eligible small businesses.

We went into more detail on accounting method changes brought on by TCJA previously on this blog.

Choosing the right accounting method for you

Although the accrual method is more commonly used, particularly by publicly-traded companies, each accounting method has unique advantages and disadvantages. Understanding the impact of both methods is essential for businesses, investors, and individuals in making financial decisions.

When deciding between cash basis and accrual basis accounting for your business, several factors should be considered, including the size and complexity of your operations, compliance requirements, and the level of financial insight needed for decision-making.

Small businesses and sole proprietors may find the simplicity of cash basis accounting appealing, while larger companies or those with more complex transactions may benefit from the greater accuracy and detail provided by accrual accounting.

In some cases, businesses may opt for a hybrid accounting system, incorporating elements of both cash-basis and accrual-basis accounting. It’s crucial to consult with an accountant or financial professional to determine the best approach for your specific business needs.

Modern accounting software often accommodates both accrual accounting and cash basis accounting, allowing users to switch between the two methods as needed. This flexibility enables businesses to accurately track their financial transactions and generate reports based on their preferred accounting method.

As always, the best way to get personalized and nuanced advice about your unique tax and accounting circumstances is to reach out to an accounting professional; our team of experts stands ready to assist you with your needs.

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