Explore cash vs. accrual accounting methods. Gain insights into financial management. Choose the right approach for your business.

Demystifying Accounting Methods: Cash vs. Accrual Explained

Two big decisions often faced when starting a business are how to account for and pay taxes on income. The cash method and the accrual method are the two main ways you can account for it.

Cash Method:

The cash method is usually the preferred accounting choice to keep the records as simple as possible. With the cash method of accounting, revenue and expenses are recognized whenever cash is received or paid out. Example:

Imagine that you have started a small business and you have ordered business cards and letterhead. When the products arrive and you pay the invoice on 18 November 2005, the cash method permits you to take the deduction on your 2005 income tax return.

But some businesses are prohibited from using the cash method. C corporations can use it only if their gross revenues fall below $5 million in any particular year. Neither is there any limit for Professional Service Corporations. And for a farming corporation the cash method is available if gross revenues fall below $25 million. Tax shelters are not allowed to use the cash method.

Accrual Method:

But the Accrual Method brings greater complexity. This method focuses on when a cost is incurred, rather than when you pay for it. That might seem subtle, but it can quickly create confusion in your records.

Consider this version of the small-business scenario above: you order business cards and stationery on the evening of 18 December 2005. They arrive on the morning of 30th December, but you do not pay the invoice until 20 January 2006. When can the family deduct the expense? It depends on when the economic performance takes place.

In most cases, economic performance is closely correlated with provision of goods or services. In our example, we’d probably say economic performance happens when the business cards, stationery and invoice are delivered on 30 December, and you can claim the deduction for the 2005 tax year.

Concluding Thoughts:

Of course, the cash method provides a much simpler framework for keeping the books than does the accrual method. Obviously you should consult with a tax professional in deciding which method of accounting fits best into your business’s circumstances, but choosing to go with the cash method or the accrual method has important implications for how you will run your business from a financial perspective, and influence how you will pay and not pay taxes.

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Questions and answers:

What are the two primary accounting methods for businesses?

In terms of management accounting, there are two main methods - the cash basis and accruals basis - to which businesses can adhere.

How does the cash method of accounting work?

Under the cash method of accounting, transactions payable—or receivable—are booked at the moment that actual cash payments are received, or run out. Income and expenses are recorded when money changes hands.

What is the accrual method of accounting focused on?

In this we see the benefit of the accrual method: transactions are seen as incurred time of payment. This links better to economic performance – the provision of goods or services.

What's an example that illustrates the difference between the two methods?

So, for example, a company purchases supplies on 15 December 2022, but those are not received until 30 December and the company doesn’t pay for them until 15 January 2023. In a cash firm, an entry is made to the 2023 date when those supplies are paid for, but in an accrual firm, an entry is made to the 2022 date to recognize that expense when the supplies were received.

Which businesses are restricted from using the cash method?

In general, gross revenues over $5 million, tax shelters and professional service and farming corporations have a cut-off for using the cash method.

How does the choice between the two methods impact financial reporting?

The decision whether to use cash versus accrual methods will determine when revenue and expenses are reported on the balance sheet, which can have an effect on profitability and tax liabilities; so which method to use is an important choice for the firm.