When it comes to running a small business, understanding the advantages and disadvantages of cash vs. accrual budgeting can be extraordinarily helpful.
Both methods have their strengths and weaknesses; It comes down to what works best within the context of a particular organization. Sometimes organizations don’t have much choice in deciding on the accounting method they want to practice. Here’s a breakdown of cash vs. accrual accounting.
What’s the difference between accrual and cash budgeting?
Accrual budgeting recognizes revenue when the business earns income. The business recognizes expenses when it incurs liabilities or consumes resources. It incorporates cash flows, all projected non-cash transactions, and stock of assets and liabilities. This method lets you know what revenues and expenses to anticipate before seeing it in your cash flow.
Cash budgeting refers to the expected future cash flow for an organization during a particular time period. This can be broken down into sources and uses of cash. Sources include elements like cash sales, accounts receivable collections, and the sale of assets, while uses include expenditures from materials, labor, manufacturing, and sales and administration.
Cash budgeting is concerned solely with the money you have immediately available, unlike accrual budgeting which factors in income and expenses before the funds are actually transferred. Expenses such as depreciation and amortization are not considered with cash budgeting.
When it comes to cash vs. accrual budgeting, accrual is provides a more accurate picture of a company’s finances. Accrual budgeting is preferred, and sometimes legally mandated, for companies with paid staff. In contrast, cash budgeting can be better for very small nonprofits with no paid staff, no set programs, and little to no plans for expansion.
What is cash basis accounting?
Cash basis accounting includes revenues when cash is received and expenses when they are paid. It does not include accounts receivable or accounts payable. Per the Tax Reform Act of 1986, C corporations, tax shelters, certain types of trusts, and partnerships that have C Corporation partners cannot use cash basis accounting. With cash accounting, organizations do not pay tax on income until those funds are actually in the bank.
What is accrual basis accounting?
Accrual basis accounting allows an organization to record revenue before it ctually receives the payment and also to record expenses before paying them out. This method follows the matching principle, which states that organizations should recognize revenues and expenses in the same period. It also follows the revenue recognition principle, which states that organizations should recognize revenue as soon as they earn or project it. Organizations must meet set criteria to qualify for accrual accounting. Publicly traded companies and most businesses with investors must be or lenders must be GAAP compliant which mandates they use accrual accounting.
Cash vs. Accrual Budget:
Advantages of Cash Accounting
Cash-basis accounting is seen as easier to learn, implement and maintain because there are fewer accounts with fewer specifics compared to its accrual accounting. Additionally, cash accounting exists in the present with actual money on hand so don’t have to worry about projected incomes and expenses. Cash accounting can also have tax advantages depending on your state and the specifics of your organization.
Disadvantages of Cash Accounting
Cash accounting’s ease of use and the fact that it is generally less detailed than its accrual counterpart is actually one disadvantage since it will give less of the full picture for an organization. Organizations cannot use cash accounting if they:
- Sells products or services on credit
- Has gross receipts higher than the IRS requirements
- Needs inventory to account for income.
Cash accounting may fail to account for certain liabilities (e.g. staff vacation time.)
Advantages of Accrual Accounting
Accrual accounting is the preferred method for most organizations because it provides a more accurate representation of a company’s finances. Startups and other small organizations can typically transition from cash accounting to accrual accounting with relative ease as they grow. Investors typically prefer organizations that use accrual accounting because they see it as a sign of a permanent, well-established business.
Disadvantages of Accrual Accounting
Accrual accounting is typically seen as more time-consuming and difficult to understand compared to its counterpart. Additionally, accrual accounting can skew the short-term financial outlook for an organization. (For example, if there is a substantial delay in getting paid for an invoice.) Accrual accounting requires monthly reporting, which can be challenging for a company with limited staffing and resources.
Sometimes organizations have a limited choice in choosing between accrual and cash accounting. Cash will likely be the preferred method for smaller organizations out of practicality. GAAP-compliant organizations typically must use accrual accounting. If nothing else, an organization may transition from cash to accrual accounting as they grow. It’s also important to note that a smaller organization does not have to use cash accounting. Having a basic understanding of accrual versus cash accounting isn’t just important for the organizations themselves. It can also be helpful for an investor when deciding what they want to support.
This post is to be used for informational purposes only and does not constitute legal, business, or tax advice. Each person should consult his or her own attorney, business advisor, or tax advisor with respect to matters referenced in this post. 1-800Accountant assumes no liability for actions taken in reliance upon the information contained herein.