When you run a small business, it is natural to look at your bank account and think, “How much money did we make this month?”

But your bank balance doesn't necessarily tell you how your business actually performed.

You might have completed $100,000 of work but only collected $60,000 from customers. Or you might receive a large customer payment this month for work you completed several months ago.

This is where the difference between cash-basis and accrual accounting becomes important.

Cash vs. Accrual Accounting: What's the Difference?

The simplest way to think about it is:

Cash accounting follows the money.
Accrual accounting follows the business activity.

With cash-basis accounting, revenue is generally recorded when you receive payment, and expenses are generally recorded when you pay them.

With accrual accounting, revenue and expenses are generally recorded when they are earned or incurred, even if the cash hasn't moved yet.

For a very small business with straightforward transactions, cash accounting can be simple and practical. As a business grows, however, it may no longer give you the clearest picture of what's happening.

A Simple Example

Imagine you own a growing consulting company.

In December, your team completes $100,000 of work for customers. You send the invoices, but your customers only pay $60,000 before the end of the month. The remaining $40,000 is paid in January.

Your company also has $30,000 of December expenses, but some of those bills won't be paid until January.

Under cash-basis accounting, December's results are heavily influenced by what actually moved through your bank account.

Under accrual accounting, the December financial statements can reflect the $100,000 of revenue earned in December, along with the expenses associated with that period. The $40,000 your customers still owe you is reflected as accounts receivable.

Now you can answer a much more useful question: “How did my business actually perform in December?” That's one of the main advantages of accrual accounting.

Your Bank Balance Isn't Your Profit

This can be difficult for business owners to get used to.

You can have a lot of cash in the bank and still have a poor month. You can also have a profitable month without seeing all of the cash from that month's work.

For example, suppose a customer pays you $75,000 in January for work your company completed in December. Your January bank balance looks great. But that doesn't necessarily mean January was your most profitable month — the underlying work, and therefore the revenue, may have belonged to December.

As your business grows, separating cash flow from business performance becomes increasingly important.

When Should You Consider Switching to Accrual Accounting?

There isn't one specific revenue number where every business should make the switch. Instead, look at what's happening in your business.

Accrual accounting may be worth considering if:

  • Customers regularly take 30, 60, or 90 days to pay.
  • Your business has significant accounts receivable or unpaid bills.
  • Your revenue and expenses are becoming more complicated.
  • You're having trouble understanding which months are actually profitable.
  • Your business is growing quickly.
  • You're seeking financing or investment.
  • You need more formal financial statements.
  • You're preparing for financial reporting under U.S. GAAP.

For some businesses, cash accounting may continue to work well. The important question is whether your current accounting method is giving you the information you need to manage the business.

Switching Isn't Just Changing a Setting

Moving from cash to accrual accounting isn't necessarily as simple as changing a setting in QuickBooks or another accounting system.

Depending on the business, the transition may involve reviewing:

  • Accounts receivable
  • Accounts payable
  • Accrued expenses
  • Prepaid expenses
  • Customer deposits or deferred revenue
  • Fixed assets
  • Inventory, where applicable
  • Other balance-sheet accounts

The goal isn't simply to produce a different-looking set of reports. The goal is to make sure your financial statements accurately reflect the business.

What About GAAP?

If your business needs financial statements prepared in accordance with U.S. GAAP, the accounting requirements become more comprehensive.

A business that has historically operated on a cash basis may need to make a more structured transition when it begins preparing accrual-based financial statements. This is one reason it can be helpful to plan the transition before you urgently need formal financial statements for a lender, investor, transaction, or other business purpose. Our accounting advisory services are built around exactly this kind of transition.

The Bottom Line

Cash-basis accounting can be perfectly appropriate for some small businesses.

But if your company is growing, customers are taking longer to pay, your expenses are becoming more complicated, or you need more formal financial reporting, it may be time to take another look at how your books are maintained.

The right accounting approach depends on your business and your reporting needs.

Vorsky Advisory Group helps U.S. businesses strengthen their accounting processes, prepare reliable financial statements, and transition from cash-basis to accrual accounting when appropriate. If you're not sure whether your current accounting approach is still right for your business, we can help you evaluate where you are and determine what makes sense for the next stage of growth.