Cash Basis vs. Accrual Basis: What’s the Difference?

Author: Larry Chester, President

There are two different ways of performing accounting functions in your business: One is on a cash basis, and the other is on an accrual basis.

More often than not, your tax accountant is doing your taxes on a cash basis. Why? They don’t want you to pay taxes on money that you haven’t received yet.

However, running your operating financials on a cash basis is the WORST way to prepare your financials. When you’re conducting accounting for your company—to understand whether you’re making or losing money—you want to use an accrual basis.

Today, we have Larry Chester, President of CFO Simplified, on camera to discuss cash basis vs. accrual basis accounting. What’s the difference? Why should you use accrual basis accounting for your business? Let’s dive in.

Cash Basis Accounting

Cash basis accounting records what is happening at your bank; the money you’re receiving and the money you’re paying out.

For instance, if you had only one customer, and they didn’t pay you for three months, even while you were selling them product, you would have no sales for those three months.

Then, if they paid you in one lump sum at the end of those three months, you’ll get one large check from them. Here, you’d have a huge amount of profit all at once.

It’s the same on the expense side. Your expenses are the money you’re paying out. So, if you didn’t pay any bills for a month or two months, you would be “making” a lot of money.

However, if you paid to cover all those past due payments, you would register a HUGE loss in that month because of the high amount of cash going out of your business.

Well, on that recording of your financial transactions, how do you know whether you’re making or losing money?

Because it’s only based on when money is coming into or going out of your business, this won’t tell you whether you should:

• Expand or contract
• Hire or fire
• Buy more or less inventory
• The list goes on!

Again, if you run your financials on a cash basis, your revenue would be the amount of money that you’ve received in that particular month or year. It has nothing to do with the work you did and when you did it. It has to do with the day that the money flowed into your bank account.

This method is certainly not going to tell you whether you’re making money on the products that you’re selling.

Accrual Basis Accounting

Instead, suppose we conduct accounting on an accrual basis. What you’re doing is matching transactions at the time they occur, then matching the revenue to the expenses that relate to that individual transaction.

For example, if you have an invoice that you send out, that’s a sale. The expenses that are related to that sale include:

• Expenses for the staff that did the work for it,
• Manufacturing or service expenses, and
• The cost of you producing those services

When it comes to accrual basis accounting, it doesn’t have anything to do with when you paid the bill. It doesn’t care when the money changed hands. It only has to do with when you did the work.

You want to align those expenses and those revenues so that they all line up on the same days, weeks, or months in which they occurred.

Why do you need to align your revenue and expenses? Because accrual accounting cares about when transactions occur.

Accrual accounting doesn’t care about when you received the money or sent the money out. It only has to do with when you did the work.

If you operate your business in this way, on an accrual basis, at the end of a month, you see the absolute net of all of your revenue and all of your expenses. That net is how much of a profit or loss you had for that month.

Accrual basis accounting provides accurate financial reporting that’ll allow you to tell clearly whether you’re making money or losing money.

Interested in learning more about accounting? Read on to find out how fractional CFOs work with remote accounting teams.