Cash or Accrual Accounting: Which One Should You Use?

Many businesses have a choice between using the cash or accrual accounting method for tax purposes. The cash method often provides significant tax benefits for those that qualify, though some businesses may be better off using the accrual method. Thus, it’s wise for your business to evaluate its tax accounting method to ensure that it’s the most advantageous approach.

In this article, we will understand the difference between the cash and accrual accounting methods. Their advantages and disadvantages, and how to choose between them.

What is the Cash Accounting Method?

The cash accounting method, or cash basic, is the easiest method among cash or accrual accounting. In cash basic you record income only if you receive the cash/money, and you record expense once the cash leaves from your hand.

Let’s understand this with an example: 

Imagine yourself running a small accounting company for your clients, Albert (Client A) and Becca (Client B). Client A sends you a cheque for $4,000 for your accounting services. On the other hand, you send an invoice of $6,000 to Client B for the recent accounting service you provided. Meanwhile, you receive a $2,000 rent bill from your landlord, which is not yet paid. Additionally, you pay a $1000 electric bill. Under the Cash Basis, you record income of $4,000 because Client A paid you and expenses of $1,000 for the month, as you paid the electricity bill only.

What is the Accrual Accounting Method?

Accrual Basis accounting is more complex.  You track income when you earn it even when you forward out the invoice too.  You record expenses as you encounter them like when you receive the bill.

Let’s understand this with the same example as above:

According to the accrual accounting method, you now record the total income of $10,000 and the total expense of $3,000. Which means you record all the incomes, Client A’s $4,000 cheque, and the invoice of $6,000 you send to Client B. For expenses for count $2,000 rent bill and $1,000 electric bill.

The Advantages of Cash and Accrual Accounting

Let’s explore pros between cash or accrual accounting which method have the most benefits:

Advantages of the Cash Accounting Method

One of the cash basis’s primary advantages is its simplicity. Tracking your money is simple when you use cash receipts or disbursements to calculate income and spending. You’ll also get a better idea of how much cash you have accessible. On the other hand, the cash basis can also provide tax benefits to small firms because income is recorded later — when the money is received rather than when the invoice is issued.

Advantages of the Accrual Accounting Method

First and foremost, the IRS requires you to adopt the accrual basis if your company generates at least $25 million in revenue every year. However, even if your company’s revenue is less than $25 million, the accrual system offers further benefits.  Clear financial picture. The accrual method provides a clear financial picture of your profitability by include accounts receivable and payable. For example, suppose you own a company that sells textbooks to college/university bookstores. Your busiest times of the year will most likely be late July/early August (fall semester) and late November/early December (winter semester).  Your customers (educational institutions) purchase textbooks on credit, paying in September and January.  According to the cash basis, your busiest months appear to be January and September, as that is when you receive the cash. However, on the accrual method, you would correctly identify your busiest months as July/August and November/December. Business Financing Banks and private equity firms often demand that borrowers use accrual accounting.