Cash Method vs Accrual Method
The fundamental difference between cash accounting and accrual accounting is timing. Cash-based accounting records transactions when cash moves. Accrual accounting stipulates that business activity happens when it happens and doesn’t always depend on the timing of cash.
When comparing the cash method vs the accrual method, most people find it easier to understand the cash method.
What is Cash Accounting?
The cash accounting method records only cash transactions in the books. In the cash method, all the business owner needs to do is watch their bank account (and most business owners do). We record an expense when cash leaves the bank to pay for something. We record revenue when we receive the cold hard cash. It’s simple, but wrong. Sometimes the truth is hard to understand.
What is Accrual Accounting?
Accrual accounting is considered a closer representation of the truth. This is because most businesses buy and sell things on credit, and use cash for large capital purchases that shouldn’t affect how we think about day-to-day profitability. Accrual accounting therefore asks the business to consider when revenue has been earned, when expenses have been incurred, when liabilities have been taken on and when assets have been used up. The timing of these things may be completely separate from the timing of the cash transaction.
If you are deciding between the cash method vs the accrual method for your business, please note accrual accounting is the only acceptable accounting practice for Canadian businesses.
Cash vs Accrual and the CRA
If you want to know why Canada insists on Accrual Accounting, look no further than the Canada Revenue Agency (CRA). They want their taxes. Imagine a business had an incredibly profitable year, and were allowed to use the cash accounting method. Well, that business could simply purchase an expensive piece of equipment and use up all their cash profits. The CRA would receive no income taxes as a result.
Accrual vs Cash Basis Accounting Example
Let’s take a look at some examples of accrual vs cash basis accounting to help illustrate the concepts.
Imagine that you’ve just sold a $100k services contract to a client. The project will start in one month and last 3-4 months. You’ve agreed to take 50% payment upon signing, 25% after 3 months and the balance on completion. The client pays you $50k.
Have you earned the revenue yet?
Businesses practicing cash-based accounting would record $50k revenue immediately. Accrual based accounting asks the business to only record revenue if it has been earned. The $50k would be recorded as a deposit in your bank account and a short term liability – you get the cash but you are also on the hook to deliver something.
Let’s say your business has negotiated 90 day terms with a supplier. You can order as many cardboard boxes as you want, and you don’t have to pay for 90 days. Pretty sweet deal. But as soon as the boxes arrive, it’s unlikely that your supplier will let you get away with non payment. Accrual accounting would therefore immediately note that you owe your supplier a payment by recording an entry in Accounts Payable (AP). Let’s assume you immediately use those boxes for a customer project. Accrual accounting would record the expense straight away. How about cash accounting? Well cash accounting wouldn’t record that you owe your supplier anything, and would only record the expense after 90 days when you pay your supplier. Worse still, if you decide not to pay your supplier (you sneaky devil) there would be no expense recorded at all.
Depreciation always comes up in discussion of cash vs accrual. In our final example, we’ll consider a business that has just purchased capital equipment that will last for 5 years – computer hardware perhaps. The business pays $50,000 out of pocket. Cash accounting would record this as an expense – boom. Accrual accounting asks “shouldn’t we spread out the expense?” The business will benefit from having the computer hardware for 5 years and then have to buy again. So, accrual accounting will show that the computer hardware’s value is reducing bit by bit over the next few years. It will also show an expense incurred bit by bit each year. This smooths out the profitability, so it doesn’t look like the business takes a big hit in year 1 and is extremely profitable in years to come.
Cash vs Accrual Accounting for Small Business
There’s no question about it, accrual accounting is harder for small businesses. Cash accounting requires fewer entries – perhaps just two, where accrual accounting would have 4 or more. Accrual accounting also requires judgement and expertise, since the business must decide how to depreciate things, when to recognize revenue and when expenses have been incurred. Cash accounting is also easier because all you have to do is explain every entry in your bank statement, whereas this is only the start of the story with accrual accounting. This is why it is very important for businesses to implement systems and get help.
Top Tips for Implementing Accrual Accounting
Done well, accrual accounting becomes consistent, reliable and easy. Here’s our top 4 tips:
- Use an accounting software such as Quickbooks Online or Xero.
- Drive your business using the functions of the accounting software or integrations. Good news, Quickbooks Online, Xero and integrated apps can help you raise invoices and vendor bills, make payments and collect fees – making it easier to run your business, get paid and pay bills on time. Don’t raise invoices manually. Just by running your business out of your accounting software, you’ll be well on your way to accrual accounting.
- Get help. Ask an accountant to set up your systems and data flows. Make sure you understand accrual accounting in your business, not just Tax.
- Set policies. Write down your rules or logic behind when you’re choosing to recognize revenue, incur expenses, etc. Your accountant can help you turn these into accounting policies, applied consistently.
Contact us for help with accrual accounting for startups and small business. Entreflow is a Canadian accounting firm in Vancouver and Toronto. We have years of expertise working with innovative fast growing companies, setting up accounting software and policies and offer flexible business accounting services throughout Canada.