Cash vs. accrual accounting: advantages & disadvantages

With cash accounting, expenses and revenues are recorded when cash goes out or comes in. With accrual accounting, they’re recorded when incurred, whether the money has actually changed hands or not.

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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 ensure it stays there.

Cash vs. accrual accounting

The primary difference between cash and accrual accounting lies in the timing of recording expenses and revenues.

• In cash accounting, also known as cash-based or cash basis accounting, revenues are reported on the account statement only when cash is received from the client. Similarly, expenses are recorded only when money is paid out, irrespective of when goods or services are purchased.
• In accrual accounting, also called accrual-based or accrual basis accounting, revenues are recorded as soon as the product or service is delivered, with the expectation that the customer will pay soon. In simple terms, revenues are reported before the cash arrives. Expenses for goods and services are also recorded immediately when the bill is incurred, irrespective of when the money is paid out.

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Here’s a closer look at each of these accounting methods.

What is accrual accounting?

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Accrual basis accounting records revenues and expenses when they are incurred. It doesn’t matter when the money is received or paid.

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For instance, you deliver a shipment in July, and the client pays you 60 days after the invoice is raised. In accrual accounting, that revenue is recorded in July, though you don't receive payment until September.

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Accrual accounting gives you a more realistic picture of your business’s financial health because it tracks all income and expenses. This offers long-term insight into your operations.

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However, that doesn't reflect the actual cash flow of the business. Your business might appear to be doing well when your bank accounts are empty, and vice versa. Accrual accounting without real-time expense tracking can devastate your financial health.

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What is cash accounting?

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Cash accounting documents revenues when cash comes in and expenses when disbursed. It doesn’t consider money business owners owe or what’s owed to them—also known as accounts payable and accounts receivable.

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Revisit the example above. You deliver a shipment to a client in July and are paid in September. If you use the cash-based method of accounting, you won’t record that revenue until you receive payment.

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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. However, that doesn't match revenue with expenses and can provide a distorted view of your business’s financial health.

Pros and cons of accrual accounting

Here are the ups and downs of recording revenue and expenses as they’re incurred:

Advantages of the accrual method

• 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 future-proof: 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.

Disadvantages of the accrual method

• Slightly more complex: Accrual accounting requires you to track multiple accounts, such as unearned revenue, accounts payable, receivables, and liabilities. You can overcome these challenges with the right accounting solution.
• 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 the customer clears the invoice. You can overcome this inefficiency with a monthly cash flow statement, which reports the money coming in and out of your business.

Pros and cons of cash basis accounting

These are the pluses and minuses of recording revenue and expenses when the money actually comes in and goes out:

Advantages of the cash method

• 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.
• Offers a clear picture of cash flow: 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.
• Can help lower your taxes: Let's say your fiscal year ends in December 2025. You raise an invoice to a customer in December but won't receive payment until January 2026. With cash basis accounting, this invoice will be part of your taxable income for 2026, reducing your tax liabilities for 2025.

Disadvantages of the cash method

• Provides limited insight: 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 $25 million threshold, you have to use accrual accounting.

Why is it important to choose between cash vs. accrual accounting?

Determining your business’s accounting method is a critical early decision. Once you pick either cash or accrual—the two most popular—you can't readily reverse it.

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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.

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A switch between cash vs. accrual accounting means adjusting your timing in terms of when you record transactions. You’ll have to change your financial statements to include accrued revenues and expenses, update your policies for revenue and expense recognition policies, and modify your tax reporting.

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Switching from accrual to cash accounting, on the other hand, involves reversing these changes. It may be easier if you’ve kept detailed records.

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A careful analysis of the pros and cons of both options will help you select the right accounting method for your company's needs.

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How to choose the right accounting method for your business

Your choice of cash vs. accrual accounting for your business often depends on factors such as size, amount of inventory, and legal requirements. Here’s how your company’s characteristics can help determine the right method for you:

• Size: Small businesses usually prefer cash accounting as it's easier to understand and maintain. Companies with high revenues and complex operations often benefit from accrual accounting, as it gives a clearer view of financial health.
• Inventory: Retailers or businesses with little to no inventory often choose cash basis accounting since they don’t necessarily 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.
• Legal requirements: Some smaller businesses operating below a certain revenue level may not have to use accrual accounting and can choose cash accounting instead. In some jurisdictions, businesses larger than a certain size or in specific industries might be obligated to use accrual basis accounting.

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Simplify expense tracking and cash management with Ramp

Whether you choose cash or accrual accounting, we can help. Ramp makes it easy to keep track of your business expenses and streamline your financial reporting. You'll know exactly how much money your business earns and how much goes out.

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We eliminate the guesswork of managing your company's finances. Companies that use Ramp accounting save an average of 5% across all spending in their first year. On top of that, Ramp’s extensive accounting integrations help them cut the time needed to close their books by an average of 22%.

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Your time is valuable. You should spend as little of it as possible on generally accepted accounting principles and busywork. Automate your accounting with Ramp—devote that time to improving your bottom line and scaling operations.