As an entrepreneur running an online business, understanding the critical differences between accrual and cash accounting is essential. These two accounting methods seem similar but fundamentally different in how financial transactions are recorded.
Accrual accounting income and expenses as transactions happen, whether you have or have not received cash.
In contrast, cash accounting records revenues and expenses only when cash transactions have been made.
This article will provide an overview of these two accounting methods and their respective strengths and weaknesses to help you choose the right approach for your online business. So, hang on to learn more!
Cash accounting is when you record revenue and expenses when the cash is in. Accrual accounting is when you record transactions as soon as you earn or owe them.
To give you a better idea, let's bring out a sample transaction from MPOM Pet Supplies' general journal.
| Cash Basis Accounting | ||
| Date 2022 | Account Title and Remarks | Amount |
| July 30 | Cash Sales Revenue(to record cash collected) | $5,000 |
| Accrual Accounting | ||
| Date 2022 | Account Title and Remarks | Amount |
| July 1 | Accountable receivable Sales Revenue(to record sales) | $5,000 |
| July 30 | Cash Accounts receivable(to record cash collected) | $5,000 |
The cash basis accounting table shows that the transaction was only recorded on July 30. That's because that is the only time they received actual money. However, in an accrual accounting table, the accounts receivable are already recorded on July 1, even if the funds are only received on July 30.
Cash basis accounting has no accounts receivable and accounts payable. You input the transaction only when cash is available and when you receive payment. Meanwhile, in accrual accounting, the transaction is recorded the moment the transaction is made, even without the actual money.
Cash-based accounting is the simplest and most straightforward way to track financial transactions. The central idea is to record revenue as soon as it's received and expenses as soon as they're paid instead of waiting for invoices or withdrawals. Check the great things about using the cash-based accounting method:
Money goes in, and money goes out. When it does, you record it. It's easy to manage your online business this way, and you don't need to hire a professional accountant to do the job. You don't need to adjust if a customer doesn't pay or you haven't paid your supplier yet. It's because there's no initial record of it while it’s unpaid.
With the cash basis accounting method, you get an upfront report of how much you earned or paid during that period. This is perfect when making short-term cash flow statements since you only record ongoing and outgoing cash transactions. You get the net income or net loss quickly.
If you only keep records of cash transactions, you may have the upper hand when you need to file for your business taxes. It's because you can lower your tax liabilities by slowing down your revenues or speeding up your expenses. Of course, this is all legal.
Cash-based accounting is a recording method that relies solely on cash inflows and outflows. This may offer a straightforward approach but can have significant drawbacks. These would include a lack of real-time insights, difficulty tracking accounts receivable, and potential inaccuracies in financial reporting.
| Month | May | June | July |
| Revenue | $15,000 | $2,000 | $5,000 |
***MPOM Pet Supplies Comparative Income Statement for May, June, July (in thousands of US dollars)
In this comparative income statement, MPOM received the most income during May, making it look like the online business is doing well. On the other hand, coming June and July, its profits fluctuated. This might suggest the company was busy in May, but the additional two months were stale.
What happens if it only gives a rough idea of your business standing in given periods?
The small business owner might make wrong business decisions. They may reduce inventory in June and July since no one was buying their products during those months. They could also make more purchase orders for May since it's the busiest, thus adding more billables that month. When in truth, there were accounts payable and accounts receivable that weren't taken into consideration in all months.
You can make the best decisions for your company when you only see revenue and not the totality of your business's financial health.
Whether your online business is slow or not, it's impossible to remember every cash transaction coming in and going out of your business. So, if you review your last year's income statement, you won't even remember why your revenue was low, or your expenses were high back then.
Generally Accepted Accounting Principles (GAAP) are accounting standards businesses and the US SEC commonly adopt. Cash-basis accounting is a non-GAAP-compliant method, but it doesn't mean it is illegal.
GAAP does not function as legal regulations. Instead, they serve as the standard accounting guidelines set by accounting boards that businesses adhere to. According to the IRS, if you earn over $25 million in sales in over three years, you must use the accrual accounting method.
Are you a sole proprietor starting an online business? You may have a passion for running a business but don't know how to do accounting. If so, the cash method is for you.
Meanwhile, you can use cash basis accounting if you are still a low-income or cash-strapped company. With cash basis accounting, you'll have lower taxes since your income during this period is expectedly low.
Accrual accounting recognizes revenue and expenses as soon as they are earned or billed. Once your customer buys your product on installment, you record the transaction when the order is completed.
Meanwhile, expenses, such as raw materials for inventory, are recorded as soon as you receive them. Therefore, line items such as accounts payable and accounts receivable are particulars in your books.
Accrual accounting is not known for ease of use, but there are many advantages to using the accrual method of accounting for your online business. Here are some of them:
When accounts payable and accounts receivable are reflected on a financial statement, you have a more accurate view of your company's assets and liabilities. You'll be provided with these details when you practice accrual accounting. Having a holistic view of your company's finances will allow you to make accurate decisions that will positively impact your finances.
Accrual basis accounting allows you to gauge and plan for peak months of your business operations as you can see your business's profitability and performance clearer.
Did you receive a lot of orders for the month? Or did you make several dealings with the supplier at that time? The accrual method shows you the exact movements of your business operations so you can make better financial decisions in the long run.
If you're not hitting the $25 million mark yet, you can still use the cash basis method for recording your income and expenses. But beyond that, accrual accounting is what the board of accounting regards as a standard. Moreover, banks, lenders, and investors prefer this GAAP-compliant accounting method over cash basis accounting.
Your business may just be starting, but you can triple your revenue in a few years, thus earning over $25 million. So, if you use accrual accounting from the beginning, you do not need to change accounting methods as you already comply with IRS regulations.
Accrual basis accounting can help business owners like you determine your financial position accurately, but it also has several drawbacks. Knowing these significant drawbacks will allow you to work on your accounting system to ensure smooth accounting proactively.
For some, bookkeeping is already daunting, and it gets even more complicated with accrual accounting's daily records, end-of-the-month, and end-of-the-year reports. You need to learn this accounting method well to use it properly.
You can see that your income or profit and loss statement looks good using the accrual method. However, upon checking your cash flow statement, your cash is almost $0. That's because when you look closely at your P&L statement, your accounts receivable is relatively high. After all, your customers haven't fully paid yet.
Following the accrual accounting method keeps track of your profitability but not your actual cash. Thus, making cash flow statements that go hand-in-hand with your P&L is essential.
Despite its tedious workflow, accrual accounting is still the standard. Small business owners choose to work with this method because they live in some states in America, like New York, requiring accrual basis tax returns. You can select accrual accounting at your own will, as you must switch to the accrual method once you begin earning larger profits.
Each method has its strengths and weaknesses, and choosing the right approach for your online business depends on your specific needs and goals.
Cash accounting is straightforward. It is perfect for small business owners with limited resources who have just launched their venture. In contrast, accrual accounting provides accurate financial reporting that reflects your business's current financial position, making it ideal for business owners looking for better projections and decision-making in the long run.
Whether you choose cash accounting or accrual accounting, it's essential to understand the method's drawbacks and ensure that your accounting system works smoothly.
Don't waste your time deciding which accounting method to use. We here at Unloop can assist you with your bookkeeping and accounting needs. Book a call with us today!
Unloop is the first and only accounting firm exclusively servicing ecommerce and inventory businesses in the US and Canada. With the power of people and technology, our team dives deep into COGS and inventory accounting. You are paired with a dedicated bookkeeping team that prepares accurate financial statements, financial forecasts, and can also pay bills or run payroll for you. Come tax time, everything is organized and ready to go, so you don't need to worry. Book a call with an ecommerce accountant today to learn more.