Cash or accrual accounting: which one shows how your business is really doing?
You finished a big project in December and sent the invoice, but the client paid in January. Did you earn that money in December or January? It sounds like a technicality, but the answer changes your monthly results, sometimes your taxes, and how clearly you can see your business. It depends on which accounting method you use.
Two ways to decide when something counts
Under cash accounting, income is recorded when you receive it and expenses when you pay them. Your books mirror your bank account.
Under accrual accounting, income is recorded when you earn it, usually when you deliver the work or the product, and expenses when you incur them, even if no money has moved yet. Unpaid invoices appear as accounts receivable; unpaid bills appear as accounts payable.
The same business, two pictures
Imagine a consultant who completes a $12,000 project in December and is paid in January. They also prepay $3,000 in December for software that covers the whole next year.
Under cash accounting, December shows $3,000 of expenses and no income from the project, and January shows $12,000 of income. December looks like a loss, January like a great month.
Under accrual accounting, December shows the $12,000 of income, because that’s when the work was done. The software is recorded as a prepaid expense and spread across the following year at $250 a month, because that’s when it’s used.
Neither picture is wrong. Cash accounting tells you what happened in your bank account. Accrual accounting tells you what the business earned and what it cost to earn it, which is why it usually gives a clearer view of profitability over time.
The trade-offs
Cash accounting is simpler. It needs fewer adjustments, and it’s easy to understand because it matches your bank balance. Many sole proprietors and very small businesses use it. Its weakness is that results can swing with the timing of payments, hiding whether the business is actually becoming more or less profitable.
Accrual accounting takes more work. It requires tracking invoices, bills and prepaid or accrued items. In return, it matches revenue with the expenses that produced it, which makes month-to-month comparisons more meaningful. Lenders and investors often expect it, and businesses above a certain size are generally required to use it for taxes.
Taxes and the choice
For federal taxes, many small businesses can choose the cash method, as long as their average annual gross receipts stay below an inflation-adjusted limit, currently in the tens of millions of dollars, and certain other conditions are met. The method you choose generally needs to be applied consistently, and changing it later may require IRS approval.
Because timing differs, the two methods can shift income from one tax year to the next. In the example, cash accounting would put the $12,000 in next year’s taxable income; accrual would put it in this year’s. A tax professional can help you choose a method that fits your business.
Using both views
Many small businesses keep their books on one method and still watch the other view. A business on accrual accounting should watch cash flow closely, because profit can look healthy while cash runs short. A business on cash accounting can keep a list of unpaid invoices and upcoming bills to see what’s coming.
There’s more on the gap between the two in why a profitable business can be short of cash.
The takeaway
Cash accounting follows the money; accrual accounting follows the work. Cash is simpler and matches your bank balance, while accrual shows more accurately whether the business is profitable. Whichever you use, knowing what the other would show helps you avoid being surprised.
Sources
Keep reading
This article is general education about US personal finance, based on the assumptions and sources described in it. It isn’t financial, tax or legal advice, and examples use hypothetical people and figures.