What’s the Difference Between Cash and Accrual Accounting?
April 25, 2023
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The Differences between Cash and Accrual Accounting
Cash-basis and accrual-basis accounting are the most common accounting methods to track revenue and expenses for landlords. One approach will probably be better than the other depending on your specific rental business.
It’s important to find the best bookkeeping methods and ensure your business model meets government requirements.
Let’s dive into each method, look at their differences and see which one is right for you.
The Core Differences
You need to understand the core differences between cash and accrual accounting to choose the right one for you. The cash method of accounting is all about your business’s cash flow, tracking money that comes in as revenue or gets paid out as expenses paid. Accrual-basis accounting focuses on when an action results in earnings or accrues an expense.
The major difference between the two approaches is timing. Cash-basis accounting tracks transactions the moment you receive money or the moment you send money out. The accrual method, on the other hand, focuses on earnings the moment they’re owed to you and expenses the moment you owe them. With this method, the moment the money goes out or comes in is irrelevant.
What Is Cash-Basis Accounting?
Cash-basis accounting centers on cash flow, with a specific emphasis on cash on hand. For newer or small businesses maintaining profitability is critical. Thus, it’s often useful to know exactly how much case you have if your business is smaller.
When Should you use the Cash Method?
Specific businesses can benefit from using this method. Here are a few examples:
- Sole proprietors and smaller businesses. The straightforward nature and ease of use make this method appealing to many smaller businesses. Furthermore, their earnings are typically below the $25 million annual restriction, making this system unavailable for income tax calculations.
- Businesses without inventory. Businesses need to account for their inventory at the beginning and closing of every tax year. With cash accounting, this isn’t easy because it focuses on the flow of money instead of tracking the movement of inventoried goods. That said, businesses without inventory can use the cash-basis accounting approach with few issues. Furthermore, small businesses under the $25 million annual restriction can treat inventory as supplies and non-incidental materials.
- Businesses that only deal in cash. This isn’t as common as it used to be. However, some businesses don’t accept credit cards or Venmo. Most likely, these companies don’t need to worry about credit-related liabilities.
Cash-Basis Accounting for Income Taxes
There are two major reasons many businesses like using the cash method for income taxes. First, the cash method easily allows businesses to track and highlight information related to annual revenue, expenses and incurred losses. Second, for businesses that focus on incoming cash flow, it’s simple to line earnings up with important dates, which makes it seamless to pay taxes on time.
The Downside to the Cash Method of Accounting
As with anything, the cash method does have its own share of issues:
- This method doesn’t always provide great insight into when a company earns income or covers its expenses because it tracks cash flow instead of accruals. Without a record of accounts receivable or accounts payable, it’s not as easy to see a business’s current financial health, which can be especially tricky for potential investors.
- This method also doesn’t always provide a great look at assets or liabilities. Strictly cash-basis accounting may leave out key information regarding unpaid invoices and liabilities. Naturally, this can also lead to the omission of specific assets.
While this method is quite effective for many small businesses, if you want to focus on the overall financial health of your business and critical data points aside from cash flow, you may be better off choosing a different method.
What Is Accrual-Basis Accounting?
Accrual-basis accounting tracks revenue when it’s earned and expenses when they’re incurred. Thus, accounts payable and accounts receivable are key cogs for this system. These accounts help formulate an up-to-date picture of the financial health of your business.
Accounts payable is money your business owes to other organizations, creditors, etc. Accounts receivable, on the other hand, is money owed to your business for services rendered.
The current status of a bill or invoice is what companies using this method track. For instance, if you have a long-term relationship with a client, the documentation will shows services rendered, the dates invoices were generated and the status of those invoices. These documents show when you receive payments and any invoices that are still outstanding.
Furthermore, you can show which bills your business has already paid and any expenses or liabilities that you still need to attend to. This method allows you to track the specific situation of every sale or bill in real-time.
Because of these points, the accrual method provides a better assessment of your business’s financial situation than the cash method.
When Should you use the Accrual Method?
Accrual accounting is necessary for many larger businesses, as they usually have too many financial complexities to use the simpler cash method. Here are a couple examples of when you should use the accrual method:
- Businesses that accept or make credit card payments. It typically takes time for credit-based statements to arrive. Cash, on the other hand, is almost always more immediate. And many credit card payments can post weeks after the transaction occurs.
- Businesses that track assets and liabilities. This method makes it easier to track assets and liabilities by keeping up-to-date records of what items fall into each category and the length of time that they do.
Beyond these points, the accrual method also provides a holistic picture that cannot be manipulated. The cash method makes it easier to misconstrue the financial state of a business as we’ve mentioned earlier. The accrual-basis approach, however, makes it so that every piece must be accounted for in a timely manner.
The Downside to the Accrual Method of Accounting
Despite being a highly trusted and preferred form of accounting, an accrual bookkeeping setup comes with disadvantages:
- This method is quite complicated. It requires in-depth record-keeping and organization. Software can help, but if you’re not accustomed to this type of accounting, it can present a steep learning curve.
- It can be time-consuming and a bit costly. Keeping detailed records year over year and consistently checking for changes and updates is time-consuming. If your business gets unmanageable, you may want to consider outsourcing most of your accounting
The better option for your rental property accounting depends on what kind of rental business you’re running. Smaller businesses with simpler operations often benefit more from the cash method. Larger businesses with more complex operations typically need to use the accrual method.
The key is to do your research and choose the best accounting method for you and your business.