Customers owe your business money. Your business owes its vendors money. Would you rather keep track with records in your books, or just in your head? That, in a nutshell, is the difference between cash-basis and accrual accounting.
That is what’s at stake as you choose between cash-basis or accrual accounting. It turns out that all business bookkeeping is going to be either cash basis or accrual. Those are the rules—just ask your small business accountant or take a look in your accounting software. It’s one of the first decisions you’ll need to make when you set up your business’s books.
And there is some good news in this area. Accrual may sound off-putting but it’s better, and it’s also easy to understand, once you get over the sound of it. Give me just five minutes to read this blog post, and you’ll get it.
Cash basis sounds simple—but it isn’t
Unfortunately, the phrase “cash basis” sounds much better than the buzzword “accrual.” Right? Doesn’t cash basis sound much more hands-on, intuitive, and practical than accrual?
Cash basis hides information
But cash basis isn’t simpler, or more intuitive, or better than accrual accounting. Cash basis means that until the money actually changes hands, you don’t keep track of it—the transaction doesn’t go on the books.
In cash basis accounting, if you sell goods and don’t get paid immediately, the sale doesn’t show up on the books. Sure, there was a sale, and now somebody owes you money. But cash basis bookkeeping ignores it. That sale gets into your books only later, when you get paid. The money your customer owes you doesn’t show up. You keep track of it in a shoebox, or maybe in your head.
Also, in cash basis accounting, when you order some goods, nothing happens. Sure, you now have an obligation to pay; you’ve agreed to spend some money. But it’s not in your books. When the goods come, if you don’t pay for them in cash when they arrive, nothing happens. Yes, you have a debt at that point, but it doesn’t go into your books until you pay it. You keep track of it in a shoebox, or maybe in your head.
Cash basis is suitable for extremely simple, cash-only businesses
Cash basis bookkeeping, as it turns out, is better for only the very simple hands-on businesses that manage everything in cash.
What kind of business is that simple? It’s hard to think of examples. Even the handicrafts vendor at the local flea market has to buy materials in advance. Even food carts want to pay their vendors regularly, but not immediately.
During the decades that I lived off a consulting practice, even though inventory was irrelevant and I had no vendors willing to extend me credit, I was still better off with accrual accounting. Why? Because my client companies never paid immediately; they paid me only after receiving an invoice and taking weeks to process.
Accrual accounting is better
In accrual accounting, when you make a business-to-business sale on account, you record the accrued amount as accounts receivable, so you keep track of the amount, the date, and the customer who owes it to you. Unless you never sell without immediate payment, accrual basis is better. Otherwise, you’re just in the dark about your cash flow.
In accrual accounting, when you receive the goods you ordered, but you don’t pay for them immediately, you still owe that money. You have an invoice to pay. You record the accrued amount as accounts payable, along with the date, a record of what you bought, and who and when you are supposed to pay.
And with that, in accrual accounting, your bookkeeping software keeps track of these important amounts and reports on them as often as you want.
Keeping track of balances
The illustration here below, from a sample business plan, demonstrates the huge advantage of accrual accounting: it keeps track of money owed to the business (accounts receivable), the value of inventory, and money the business owes (accounts payable).
That gives a business owner an instant accounting of the true financial position, with no surprises, no forgetting what’s still coming and still needing to be paid.
When in doubt, go for accrual basis
I’m so sorry that the accounting standards that were set a few generations ago chose to call it “cash basis” when you don’t record money owed into your books until it’s paid, or money you owe until you pay it. It’s a terrible idea to keep that information in your head instead of in your bookkeeping.
Furthermore, as your business gets going, banks and financial analysts tend to mistrust cash-based bookkeeping because it can hide—whether intended or not—financial realities. For example, as a loan manager looks at a potential business loan, they want to know what the company really owes (accounts payable), its inventory performance, and how much it’s owed (accounts receivable) too.
Frankly, cash basis bookkeeping can too easily cause many mistakes as we business owners fail to keep track and remind ourselves of these outstanding obligations. And yet, ironically, they call that “cash basis” accounting. I do wish that the right way to do it, which is accrual accounting, didn’t have such an off-putting name.