One of the most important financial reporting decisions new and growing companies need to make is whether to use cash vs. accrual accounting for their financial records. Each approach offers potential advantages and disadvantages for companies in different situations. Choosing the best method for your company depends on understanding your needs and financial reporting goals.
Under cash-basis accounting, companies recognize revenue as customers pay for purchased goods and services. Similarly, they recognize expenses as they pay for them. This method, often used by small businesses and sole proprietorships, is usually favored for its comparative simplicity.
Under accrual-basis accounting, revenue and expenses are recorded when transactions occur, not when cash is received or spent. By including accounts payable, accounts receivable, and other accounts, accrual accounting provides a more accurate view of a company’s finances that conforms with Generally Accepted Accounting Principles (GAAP). An additional consideration is that companies that have averaged gross receipts in excess of $25 million over the past three years are required to use accrual accounting for income tax filings.
Advantages and Disadvantages of Cash-Basis Accounting
The primary advantage of cash-basis accounting is its simplicity. The company recognizes revenue as it receives cash, and records expenses as they are paid. This approach is easy to understand and may be suitable for companies that do not have financial reporting or management capabilities.
Cash-basis accounting helps a company understand clearly how much cash it has on hand. This can be helpful for a business with tight cash flows. Cash-basis accounting may also provide potential tax benefits by allowing a company to delay the recognition of revenue into a future period and accelerate deductions into a current period.
As a potential disadvantage, cash-basis accounting can provide an inaccurate picture of a company’s financial health and performance. It fails to account for upcoming expenses or revenue.
For example, the finances of an agricultural company may be difficult to assess accurately because it records most of its expenses when crops are planted, and most of its revenue as those crops are harvested. This challenge can be accentuated when revenue and expenses tend to fall within different reporting periods.
Cash-basis accounting also does not conform with GAAP. This can be an issue if the company seeks loans or outside investments.
Advantages and Disadvantages of Accrual-Basis Accounting
Because it includes both prior and future transactions, accrual accounting provides a more accurate picture of a company’s financial performance and health. Accrual offers a more consistent view of a business’s finances by recognizing revenue and expenses as they’re incurred. This can help management prepare more accurate financial reports and forecasts.
Similarly, accrual accounting enables companies to track asset and liability accounts that wouldn’t be included under cash-basis accounting, such as prepaid expenses, work in progress, accounts payable, accounts receivable, and others.
Accrual accounting complies with GAAP, which is required for publicly traded companies and is usually preferred by banks and outside investors. It provides more accurate information for internal management to make better business decisions.
A potential disadvantage of accrual-basis accounting is its relative complexity compared to cash accounting. The company needs finance professionals who understand accounting principles and may need outside accounting assistance to support its financial reporting needs.
Comparing the Two Accounting Methods
Choosing the best accounting approach for your company depends on several factors, starting with the size and complexity of your organization. A smaller company with simple transactions, for instance, may find cash-basis more suitable. Medium-sized businesses with more complex operations, or that plan to attract outside investors, may prefer accrual basis.
Similarly, a company that is public, or is considering going public, will need to comply with GAAP and related regulatory standards (including the use of accrual-basis accounting).
Tax considerations can also play a role in deciding whether a company should adopt cash or accrual accounting. Timing the recognition of revenue and expenses in different periods may affect an organization’s tax liabilities.
Cash-basis accounting is usually less expensive to implement and maintain, but may not provide the detailed insights into the company’s financial results that more complex businesses need.
There are several reasons for a small business to adopt the accrual method of accounting, including reduced financial reporting variability and the ability to attract financing from lenders and investors who prefer GAAP financials. If your company is eligible for the cash method for tax purposes, you may prefer the simplicity and the flexibility it offers.
Whichever method a company chooses, it’s important to follow that accounting basis consistently. For instance, a company that uses cash-basis accounting, but starts to accrue unpaid invoices, can create a misleading picture of its finances and its performance.
Contact us to discuss your questions related to cash vs. accrual accounting methods and let us help you make the optimal choice for your situation.
