Cash vs. accrual accounting: Key differences and which to choose

You already know that accounting is more than just bookkeeping. How you manage your finances lays the foundation for your overall business strategy.

But do you know the difference between cash accounting vs. accrual accounting? And more importantly, do you know which one is right for you?

In this article, we explore both accounting methods by comparing and contrasting cash and accrual accounting, and then provide some best practices to help you decide which one works best for your business.

Overview: Accrual accounting vs. cash accounting

The primary difference between cash and accrual accounting lies in when you record expenses and revenues. With cash accounting, expenses and revenues are recorded only when cash enters or leaves your business. With accrual accounting, expenses and revenues are recorded when they're incurred, regardless of whether any money has been transacted.

Let's break down this distinction in more detail:

• In cash accounting, also known as cash basis accounting or cash-based accounting, you report revenues on the account statement only when you receive cash from the client. Similarly, you record expenses only when you pay money out, irrespective of when you purchased goods or services.
• In accrual accounting, also called accrual basis accounting or accrual-based accounting, you record revenues as soon as you deliver your product or service. In simple terms, you report revenues before the cash arrives. You also record expenses for goods and services as soon as you incur the bill, regardless of when you actually make a payment.

It may sound like a minor distinction, but it isn’t. Choosing between cash and accrual accounting allows you to understand your business’s financial health, put it on the right path, and make sure it stays there.

What is accrual accounting?

Accrual accounting recognizes income and expenses when they occur, regardless of whether the money has actually been received or paid out.

Key features

• Revenue and expenses recorded when they occur: Accrual basis accounting records revenues and expenses when they're incurred. It doesn’t matter when you receive or pay the money.
• More accurate financial picture: You’re recording all your revenues and expenses in real time, giving you a more realistic picture of your business’s financial health and long-term insight into your operations
• Required above a certain revenue threshold: Businesses whose average annual gross receipts exceed a certain threshold are required to use accrual accounting for tax purposes. In 2024, that threshold was $30 million. Any company below that threshold has the option to use either.

With accrual accounting, accounts receivable and accounts payable are crucial to ensure that the money is actually received or paid out. The matching principle recognizes revenue and expenses to show profitability. Failing to account for this with real-time expense tracking can devastate your financial health.

What is cash accounting?

Cash accounting, commonly called cash basis accounting, records income when you receive it and expenses when you pay them.

Key features

• Revenue and expenses recorded when cash is received or paid: Cash accounting documents revenues when cash comes in and expenses when disbursed. It doesn’t consider the money business owners owe or what’s owed to them. In other words, it doesn't consider accounts payable or accounts receivable.
• Simpler for small businesses: The upside of cash accounting is that it provides an accurate picture of your business’s cash flow. You can view a statement and see the cash at your disposal, which is very when you’re running a smaller operation.
• Not GAAP-compliant for larger businesses: Generally Accepted Accounting Principles (GAAP) prioritize the most accurate view of a company’s financial operations, which can only be accomplished through the accrual method. With cash accounting, you can view a statement and see the cash at your disposal. However, that doesn't match revenue with expenses and can provide a distorted view of your business’s financial health.

With accrual and cash accounting methods defined, let’s take a look and compare them side by side.

Key differences at a glance

To show how each method works, let’s look at a specific real-world example.

Example: Accrual vs. cash accounting in action

Let’s say you work for an office supply company. You deliver a shipment of desk furniture to a client in November. The client operates on net 60 terms, paying their invoice in January.

Recording the transaction

In accrual accounting, you record that revenue in November, even though you don’t receive payment for 60 days. In the cash-based method, you would record the revenue in January when you receive the payment.

Impact on financial statements and tax records

With the accrual method, you can see the complete picture of your revenue in November when you record the transaction. Using the cash method, you have to wait until January to fully understand your financial health and close your books.

Likewise, for tax purposes, you would record the income (and any associated deductions) in the year prior with the accrual method, while you would have to wait until next year using the cash method.

Pros and cons of accrual accounting

Pros

• Accurate and versatile: The accrual method provides you with an accurate picture of your company's financial health. It includes receivables and liabilities, helping you monitor your company's true profitability.
• Scalable and better for long-term planning: Eventually, most businesses convert from cash-based accounting to accrual accounting as their business grows and investors require more in-depth performance reports. That switch can be cumbersome. Starting with accrual accounting from the outset helps you avoid this challenge down the line.
• Required for large businesses: Once you hit a certain revenue threshold, you're required to use the accrual method

Cons

• Slightly more complex: Accrual accounting requires you to track multiple accounts, such as unearned revenue, accounts payable, receivables, and liabilities. The right accounting software can help you overcome these challenges.
• May require professional help: Tracking all your transactions in real time may not always be easy. To use the accrual method properly, you may need the assistance of an accountant and workflow automation.
• Difficult to track cash flow: The accrual method doesn't provide an accurate picture of your cash flow. The income statement might show thousands of dollars in sales revenue, but you may not receive the cash until customers clear their invoices. A monthly cash flow statement solves this, reporting the money coming in and out of your business.

Pros and cons of cash accounting

Pros

• Easy to use: The cash method is easy to understand, even if you have no prior experience with bookkeeping or a balance sheet—you simply record transactions when you pay or receive cash. All you need is a solid business expense tracker, and you're good to go.
• Real-time cash flow tracking: Cash basis accounting makes it easy to manage your business cash flow. This way, you'll know exactly how much cash you have on hand.
• Easier for a small business: Sometimes, just tracking your cash as you exchange it makes the most sense. It could also help lower your taxes. With cash basis accounting, if you invoice a customer in December who won’t pay until January, that invoice will be part of your taxable income for next year, reducing your tax liabilities for this year.

Cons

• Less accurate for long-term planning: Cash basis accounting gives you a snapshot of your company's transactions at a particular point in time. It doesn't take into account liabilities and receivables, making it difficult to see the complete picture of your financial health.
• Not suitable for all businesses: Cash basis accounting isn’t appropriate for your business if you offer credit to customers or maintain product inventory. Also, it’s easier for small business owners. If your gross receipts cross the $30 million threshold, you have to use accrual accounting.
• Not GAAP-compliant: Cash accounting isn’t GAAP-compliant, which is an indicator of transparency, standardization, and financial integrity for potential investors

Tax and regulatory considerations

It's important to understand the tax and regulatory requirements your business needs to follow before choosing an accounting method. The IRS states that you can’t use the cash method if your business is:

• A corporation with average yearly gross receipts for the last 3 tax years exceeding $30 million, although the IRS exempts S corporations from this rule
• A partnership with a corporate partner and average yearly gross receipts for the last 3 tax years exceeding $30 million
• A tax shelter as per Section 448(d)(3)

The IRS does not require GAAP compliance, but when you’re dealing with complex financial transactions, it’s best to remain consistent with accounting and tax reporting practices.

For certain industries, exceptions to the revenue threshold apply. Farming businesses, S corporations, qualified personal service corporations, and partnerships without C corporation partners can use cash accounting so long as they meet the right qualifications.

How to choose the right accounting method for your business

Whether you choose cash or accrual accounting for your business often depends on factors such as business size, inventory levels, and legal requirements. Here’s how your company’s characteristics can help determine the right method for you:

• Business size and growth plans: Small businesses usually prefer cash accounting because it's easier to understand and maintain. Companies with high revenues and complex operations often benefit from accrual accounting since it gives a clearer view of financial health.
• Industry requirements: Retailers or businesses with little to no inventory often opt for cash basis accounting because they don’t need to match inventory costs to revenues. Businesses that maintain inventory often use accrual accounting to value it and match revenues with costs in the same period.
• Need for external financing and investors: When looking for funding and investors, you want to be buttoned up and GAAP-compliant. Accrual basis accounting is likely the best option.
• Complexity of transactions: The reason cash-based accounting is better for small businesses is that transactions are usually straightforward. As you grow, your number of complex transactions increases, which is why most businesses switch to an accrual-based system.
• Tax planning needs: Some smaller businesses operating below a certain revenue threshold may not be required to use accrual accounting and can opt for cash accounting instead. In some jurisdictions, businesses larger than a certain size or in specific industries might be obligated to use accrual basis accounting for tax purposes.

A careful analysis of the pros and cons of both cash basis and accrual basis accounting will help you select the right accounting method for your company's needs. Determining your business’s accounting method is a critical early decision.

Once you pick either cash or accrual, the IRS mandates that you continue with your choice for the rest of the tax year based on GAAP regulations. And at the end of that year, changing from one to the other will take time and effort.

Simplify expense tracking and cash management with Ramp

When it comes down to it, the accounting method you choose has to do with the size and complexity of your business. If you’re ultimately unsure, consult with an accounting professional.

Whether you choose cash or accrual accounting, Ramp's accounting automation software can help. We make it easy to track your business expenses and streamline financial reporting. You'll know exactly how much money your business earns and how much goes out.

Ramp eliminates the guesswork of managing your company's finances. Companies that use Ramp cut the time needed to close their books by an average of 22%.

Your time is valuable. You should spend as little of it as possible on busywork. Try an interactive demo and see for yourself how much time Ramp can save you on your accounting operations.