What is cash vs accrual accounting

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Key Takeaways

Companies have two basic accounting methods to select from -- cash basis and accrual basis. When cash moves into/out of a startup, cash accounting is used to represent the information on financial transactions. On the other hand, regardless of when the money actually changes hands, accrual accounting acknowledges income when it is received and costs when they are incurred.
Under the cash approach, there is no need to record client credit sales (accounts receivable) unless they pay. Likewise, unless the startup pays for purchases made on credit (i.e., accounts payable or accumulated costs), no bookkeeping is needed. Therefore, cash-basis accounting is a straightforward method of determining a startup's cash position.
The matching principle and the revenue acknowledgment principle are two essential accounting concepts that are combined in accrual-basis accounting. Revenue is recorded when it is generated under these standards and costs are reported in the timeframe that best fits the revenue they assist generate. Accrual accounting recordkeeping is decoupled from when the amounts involved change hands, smoothing out the influence of time and resulting in a more precise overall picture of a company's operations.
Cash accounting is preferred by many startups since the accounting information accurately represents their cash situation, which is particularly significant for founders. The ease of use also helps make bookkeeping simpler and cheaper. A startup does not have to pay taxes on money it hasn't received if it uses cash-basis accounting.
The cash basis's primary downside is that financial reports at any one moment in time may appear skewed. Financial planning and predicting might be challenging as a result. Furthermore, GAAP does not acknowledge cash accounting, and any financial results that emerge from it are deemed inadequate by most lenders and are illegal for companies listed for public trade.
The accrual approach to accounting is the holy grail (especially for more established startups) since it represents the startup's finances more accurately. Startups of a specific size, those with specific debt covenants, or those that are traded publicly must use GAAP-compliant accrual accounting.
The extra bookkeeping required for accrual accounting is often a drawback. Instead of focusing just on cash flow, accrual accounting keeps track of receivables, anticipated costs, accounts payable, as well as other accumulated financial obligations. It also requires the closing of the startup's books on a more regular basis. Another downside of the accrual method is that it may mask short-term cash flow problems in a startup that appears successful on paper.

What is Cash vs. Accrual Accounting?

Startups have two basic accounting methods to choose from -- cash basis and accrual basis. The saying "time is of the essence" describes the most significant distinction between the two. When cash moves into/out of a startup, cash accounting is used to represent the financial transactions. On the other hand, regardless of when the money actually changes hands, accrual accounting acknowledges income when it is received and costs when they are incurred. The discrepancy in time has a domino effect on the startup's financial statements and balance sheet, affecting its tax liabilities in the process.

Each accounting approach has its own set of pros and cons. The cash approach is far less complicated. However, Generally Accepted Accounting Principles (GAAP), a collection of regulations developed by the Financial Accounting Standards Board (FASB), only recognize the accrual method. All in all, it may be fairly simple to decide which accounting method is best for your startup.

In general, cash-basis accounting is the simpler of the two approaches. Whenever a client makes a payment, the startup records it as revenue. When the startup pays vendors, it keeps track of expenditures. The resulting net profit is used to compute taxes.

Under the cash approach, there is no need to record client credit sales (accounts receivable) unless they pay. Likewise, unless the firm pays for purchases made on credit (i.e., accounts payable or accumulated costs), no bookkeeping is needed. Therefore, cash-basis accounting is a straightforward method of determining a company's cash position.

The matching principle and the revenue acknowledgment principle are two essential accounting concepts that are combined in accrual-basis accounting. Revenue is recorded when it is generated under these standards and costs are reported in the timeframe that best fits the revenue they assist generate. Accrual accounting recordkeeping is decoupled from when the amounts involved change hands, smoothing out the influence of time and resulting in a more precise overall picture of a company's operations.

What is the Difference Between Accrual vs Cash Accounting?

The main distinction between the cash and accrual techniques is when income and expenses are received/paid and when they are earned/incurred.

Cash accounting is preferred by many startups since the accounting information accurately represents their cash situation, which is particularly significant for founders. The ease of use also helps make bookkeeping simpler and cheaper. A startup does not have to pay taxes on money it hasn't received if it uses cash-basis accounting.

The cash basis's primary downside is that financial reports at any one moment in time may appear skewed. Financial planning and predicting might be challenging as a result of these discrepancies. Furthermore, GAAP does not acknowledge cash accounting, and any financial results that emerge from it are deemed inadequate by most lenders and are illegal for companies listed for public trade.

The accrual approach to accounting is the holy grail --especially for more established startups -- since it represents the startup's finances more accurately. Startups could keep records of credit transactions more efficiently using accrual accounting by adopting an accounts receivable solution which displays each client's complete transaction history. The transaction records between the startup and a vendor/supplier are displayed in an accounts payable system. Startups of a specific size, those with specific debt covenants, or those that are traded publicly must use GAAP-compliant accrual accounting.

The extra bookkeeping needed for accrual accounting is often a drawback. Instead of focusing just on cash flow, accrual accounting keeps track of receivables, anticipated costs, accounts payable, as well as other accumulated financial obligations. It also requires closing the startup's books on a more regular basis. Another downside of the accrual method is that it may mask short-term cash flow problems in a startup that appears successful on paper.

Cash Flow, Taxes, and Policy Impacts of Cash and Accrual Accounting

The accounting method used -- cash or accrual -- has a substantial influence on a startup's cash flow and tax obligations. It might also have an influence on the processes and regulations that a startup must follow. Here are a few instances:

Startups that use the cash method of accounting will not have accounts receivable ledgers and will require special methods to track atypical customer accounts.
Startups that often engage in cash transactions typically adopt the cash accounting method. They require security for cash receipts and disbursements to prevent money from being lost or stolen.
Startups that employ the accrual accounting technique have systems in place to balance bank accounts and track short-term cash flow.
Cash accounting is popular among startups and entrepreneurs because it is simple. However, as they proceed to buy shares in long-term assets or consider IPOs, they might have to modify their accounting processes.

All publicly listed corporations and most startups with investors or lenders must adhere to GAAP and employ the accrual method of accounting.

Startups with gross receipts of less than $25 million, though, have an option. Refer to IRS Publication 538 for further information on:

How to implement the gross receipt test
The IRS standards on appropriate accounting techniques
How to modify your accounting system

If your startup depends on cash payments for sales and expenditures, cash-basis accounting may be perfect for you. Accrual accounting, on the other hand, provides a better picture of the complete financial health for startups that provide credit to consumers or have credit with their vendors. Accrual accounting is particularly beneficial to startups that have a lot of inventory. In general, the longer the gap between sales and cash, the stronger the case for accrual-based accounting.

Accountants employ double-entry accounting to provide the most accurate and relevant financial accounts. There are 2 accounts for each transaction -- debit and credit. These two entries are identical and directly opposed. Everything should be listed twice to help startups identify mistakes and avoid fraud, as well as for auditing purposes. Double-entry bookkeeping can be used for both cash and accrual accounting. The 5 kinds of accounts used in accrual accounting to categorize financial operations are revenue, cost, asset, liability, and equity.

When to Use Accrual vs. Cash-based Accounting?

When deciding between cash-based and accrual accounting, there are a few more things to keep in mind:

Because a startup that uses cash-based accounting does not recognize income until it gets the actual cash, it is less likely to owe income tax on sales for which it has not yet been paid. It could be able to expedite certain costs at the end of the year, reducing its net income as well as the taxes it will incur.
In the U.S., public corporations must adhere to GAAP, which mandates the accrual accounting technique.
Many lenders and investors demand that the accrual method be used by the startups they conduct business with. Even if a startup isn't looking for external capital at the moment, if it plans to do so over the next few years, it makes sense to start using accrual-based accounting.
Additionally, some firm purchasers need certified financial accounts, while U.S. GAAP audits demand accrual accounting. If they haven't done so already, entrepreneurs who expect to sell their company in the next several years should start adopting accrual accounting.

Example of the Cash-based Accounting Method

Imagine a house-painting company that wraps up a project and sends an invoice in April, then gets paid by the homeowners via credit card in May. Under the cash-basis method, the company records the earnings when the payment is received, even if it is many weeks after the task was finished. In other words, there is a time difference between when the "economic activity" actually happened and when it was officially documented.

Similarly, suppose a painter receives a $175 energy bill for April and pays it in May. Even though the $175 covered services delivered in April, it is reported as a May cost under the cash system of accounting.

Example of the Accrual Accounting Method

When a startup uses accrual accounting, it registers a sale as soon as it sends a client an invoice. For instance, let’s say that ABC, a software firm, makes $10,000 in monthly sales. Approximately 60% of these sales are made in cash, with the remainder made on credit. Accounting professionals treat credit card payments as sales under accrual accounting, and the revenue that these sales produce includes both cash and credit sales, both of which deduct expenses and the cost of sold goods.

Summary

The IRS mandates that businesses adopt the accrual accounting method if they have (besides an S corporation) averaged more than $25 million in gross receipts over the past three years.

If your startup does not meet those requirements, you are free to use cash-basis accounting.

For startups that do not have inventory, the cash system typically works better. If you have a lot of inventory, the accountant will undoubtedly advise you to use the accrual approach.

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