When starting out, your financials can be classified under cash accounting or accrual accounting. The biggest difference between the two comes down to timing: under which conditions do you recognize and record revenue and expenses.
Cash accounting: Revenue is recognized when cash is received (irrespective of when goods are delivered or services are completed)
Accrual accounting: Revenue is recognized when goods are delivered or services are completed (irrespective of when cash is received)
In this article, we’ll help you understand 1) the building blocks of these cash and accrual accounting, 2) the pros and cons of each and 3) what is the best method to use and when. We’ll walk through specific examples to help you, as a business owner, decide what meets your needs today.
Cash accounting: revenue is recorded only when payment is received and expenses are recorded when the payment is made.
For example:
You are the owner of Jess’s Ice Cream and make a $10,000 sale order to Whole Foods, with net 30 terms. You purchase the ice cream from the copacker on March 1st, deliver the ice cream on April 1st and issue the invoice on the same day. Whole Foods completes payment on May 1st.
$10,000 of revenue is recognized on May 1st (when cash is received), not April 1st (when goods are delivered). Cost of goods sold of $5,000 is recognized on March 1st when order is placed.
1. Simplicity: Cash accounting is easier to understand than accrual accounting. It is particularly suitable for small businesses with straightforward financial transactions.
2. Cash Flow Management: Provides a realistic view of your company’s cash inflows and outflows. This can be crucial for small businesses that need to closely manage their cash flow and track how much money is on hand.
3. Tax Considerations: In the US, small businesses are able to file taxes with this method which keeps reporting fast and simple.
1. Cash accounting has its limitation for large businesses with complex financial structures
2. Revenue and expense recognition are not “tied” together. Cash accounting can create lumpy periods of very high profitability or big losses
Accrual accounting recognizes revenue and expenses when they are incurred, not necessarily when cash changes hands.
1. Accrual accounting is about timing - revenue recognition and the matching principle
2. Matching principle requires that the costs be recorded in the same period that the benefits are received
3. Revenue should be recognized when the customer obtains control of the good or service
4. Timing of revenue recognition can vary across industries
Let’s go back to the same example:
You are the owner of Jess’s Ice Cream and make a $10,000 sale order to Whole Foods, with net 30 terms. You purchase the ice cream from the copacker on March 1st, deliver the ice cream on April 1st and issue the invoice on the same day. Whole Foods completes payment on May 1st.
$10,000 of revenue is recognized on April 1st (when goods are delivered), not May 1st (when cash is received). Cost of goods sold of $5,000 is recognized on April 1st when order is delivered.
1. Since revenue and expenses are recognized in the same period, or “matched” together, numbers will appear more consistently on the P&L
2. For management reporting and investors, this view presents a more clear picture of the overall health of a business. It is easier to analyze trends and extract insights to make future decisions on
3. Sometimes your numbers can look better. Instead of recognizing all your expenses at one time, you are spreading out the cost of an expense over several months. (For example, you spend $20,000 on inventory. Instead of recognizing a large $20,000 expense in one month, you are able to recognize this expense over the course of 12 months when this inventory sells down.)
1. Complex: Accrual accounting is complex and can require several manual processes to recognize transactions appropriately. For consumer goods companies, companies have to track cost of goods sold on a unit basis and match it to the quantity sold each period. Depreciation and amortization schedules need to be created for expenses that have been paid upfront. Prepaid expenses or deferred revenue need to be tracked and checked off when the services have actually been rendered
2. This is an art! Given the amount of manual work it requires to get an accurate accrual view, mistakes can pop up or it just takes a very long time to complete. So much so, that when accrual books are ready, it may be too late to action on them
For management reporting and investors, accrual accounting shows a more “stabilized” version of your P&L. It tends to represent a more consistent of expenses relative to revenue, month over month.
We recommend the cash method for small businesses that are just starting out and in their first stages of growth: developing product, selling on Shopify, ramping up on wholesale orders and beginning to hire more employees. The cash method is a fast and no frills way to track your expenses and make sure you have enough money in the bank to service your next large inventory purchase. You can file your end of year taxes with cash accounting and is a good view to present to debt lenders.
Accrual accounting is for rapidly growing businesses that are looking for equity investors or need strategic finance help. Accrual presents a comprehensive view of the business and is needed to analyze strategic trends in the business. In subsequent articles, we’ll dive in to ways to create management reporting and how to read you P&L statement.
DayZero is here to get your books, whether with the cash or accrual method set up fast. You can sign up, sync your accounts and see your financial statements in less than an hour. Book a demo with us.
