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Differences between cash and accrual accounting

Learn the differences between the cash and accrual accounting methods and see how your online bookkeeper can help you keep up on all your online accounting demands.

Starting your business is reason enough for stress. On top of that, dealing with your finances and accounting on your own can only add to the headache. At KPMG Spark, we want to help you simplify the process and we’ve put this guide together to help you better understand your accounting. Here, we’ll lay out the differences between the cash and accrual accounting methods and how to choose which is best for your business.

Cash and accrual accounting

Cash basis accounting and accrual basis accounting are two main types of accounting that businesses employ to keep track of their finances and for tax purposes. While they both have their pros and cons, depending on factors within a business (like inventory and the size thereof) you may be inclined or required to use a particular accounting method. To put it simply, cash accounting generally recognizes your revenue and expenses exactly when the cash enters or leaves your bank account while accrual accounting generally recognizes revenues and expenses when they are earned or incurred. Here, we will dive into the differences between the two and how you can decide which one to use for your business.

Cash basis accounting

Cash basis accounting is used largely by small businesses that need to keep track of their cash flow at all times. It tends to be easier as there generally is less to track; many small businesses and a large portion of KPMG Spark clients use this method because of its simplicity. Cash basis accounting generally recognizes all revenue as it is received and all expenses when the money is spent. This means that whenever you look at your bank balance, you know exactly what resources are at your disposal. It also means that your revenue generally will not be subject to tax until the cash is in the bank (although there is also a concept of ‘constructive receipt’ for certain amounts available upon demand). While simple and easy to maintain, the cash basis of accounting does not always show an accurate image of the true financial state of a business.

For example, if your company appears to be cash-rich but has large amounts of account payables and has yet to pay them, your financial standing reflected in your bank accounts may look inappropriately good. In this case, investors might think your company is about to make a profit and continue growing but in reality, it may be losing money because of the unpaid accounts payable.

Accrual basis accounting

On the other hand, accrual accounting recognizes revenue when it’s earned and expenses when they are billed (or in some cases as earned by the counterparty). This type of accounting is more popular among larger businesses but is typically more complicated and, at times, more labor-intensive. An example of accrual accounting would be if another entity or person owes your company money; if you have already sent an invoice to your customer, then you would record the amount owed by your customer as revenue, even if the customer hasn’t yet paid you. This method is mostly used by larger businesses and is even required for businesses with average revenue exceeding 26 million dollars a year. Accrual accounting tends to provide a more realistic financial view of a business over the long term and is especially helpful for companies with large amounts of inventory.

Even though the accrual method tends to be more popular among large businesses, it does have its drawbacks. Unlike the cash basis method, the accrual accounting method does not actively track your cash flow. This can be very dangerous for businesses with a cash shortage in the short term as they can end up spending money they do not actually have because they appear to be profitable in the long term – stated differently, they have reported lots of revenue, but they haven’t been paid, so there is no cash in the bank. While using the accrual method, it is imperative to have someone tracking the incoming revenue and outgoing expenses to understand the actual cash position of the business.

Payroll accrual

An aspect of accrual accounting that highlights its complexity is payroll. Assume a company pays its employees on the fifth of the month for the prior month’s work. Because your employees have already earned their pay for the month, under the accrual method you would need to account for the pay you owe to them at the end of the month, days before they are actually paid – the amount owed is an accrued payroll liability for your business. If you expand this concept beyond payroll – for example to utilities, rents, service contracts, leases, loans, etc. -  this begins to create a long list of expenses that need to be recorded as accrued expenses (or payables). This illustrates why accrual accounting is more labor-intensive and more expensive.

Profit

While tracking expenses and trying to determine net profit, the two accounting methods, cash v accrual, will yield different results. Under the circumstances listed below, we will assess the profit of a particular month.

Item Cash Accrual
Received a payment of $2,000 from an invoice sent in the prior month Records revenue of $2,000 Does not record (revenue was recorded in the prior month)
Sent out an invoice of $500 for a project to be completed later this month Does not record (cash hasn't been received) Records revenue of $500
Paid $125 for a bill you received in the prior month Records expense of $125 Does not record (expense was recorded in the prior month)
Received a bill of $200 from a web developer finishing a project this month Does not record (cash hasn't been paid) Records expense of $200
Net profit for the month $1,875 $300

Under the cash basis accounting method, the current month’s profit would be $1,875, whereas under the accrual basis method, the month’s profit would be $300. This shows how much difference can be seen in a company’s profit and cash flow for a given period just by deciding what accounting system to use.

Bookkeeping?

As you may have noticed, the biggest difference between cash basis accounting and accrual basis accounting is when you record the company’s transactions. If you are doing your bookkeeping on your own, it is important to know the ins and outs of each system. At KPMG Spark, you get a dedicated bookkeeper who keeps track of your finances and records everything how you prefer and how your business needs it. Your bookkeeper keeps track of and records all your transactions so you do not need to stress about it. The accounting system for small businesses that we have created combines this and our unequaled software to make sure your books are in order. Visit our website and give us a call to schedule your demo now to see how KPMG Spark can help you!

 The views and opinions expressed herein are those of the author and do not necessarily represent the views and opinions of KPMG LLP.

This blog article is not intended to address or provide advice concerning the specific circumstances of any particular individual or entity and does not constitute an endorsement of any entity or its products or services.

Some or all of the services described herein may not be permissible for KPMG audit clients and their affiliates or related entities.

The following information is not intended to be “written advice concerning one or more Federal tax matters” subject to the requirements of section 10.37(a)(2) of Treasury Department Circular 230. The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser.

Ben AsplundDecember 8, 2020Posted In: Accounting Info

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