Cash vs Accrual Books, and Which One You're Looking At

Short Answer: Cash accounting records revenue when money arrives and expenses when money leaves. Accrual accounting records revenue when you earn it and expenses when you use what you bought, whatever the payment date. Cash books track your bank account closely; accrual books show whether the work itself was profitable. Check the report header or look for "accounts receivable" on the balance sheet to see which one you have.

Two owners can look at the same month of the same business and see different answers. One report says the month made money; another says it lost money. Neither report is wrong. They count on different clocks, and knowing which clock your reports use changes how you should read them.

What Is Cash-Basis Accounting?

Cash-basis accounting records a sale when the customer's money lands and an expense when you pay the bill. A job finished in April and paid in May is May revenue. Materials bought in April are an April expense, even if you use them in May.

It's simple, and it follows the bank account. Many small businesses keep their books this way, and many file their taxes this way.

What Is Accrual Accounting?

Accrual accounting records revenue when the work is done and billed, and records costs in the month they help produce that revenue. A job finished and invoiced in April is April revenue even if the check comes in May. Materials bought in April for May jobs wait on the balance sheet as inventory and become an expense in May, when they're used.

Accrual books need two extra accounts. Accounts receivable holds what customers owe you. Accounts payable holds what you owe suppliers. Those two accounts are what let accrual profit and the bank balance drift apart.

A Worked Example: One April, Two Answers

Take a hypothetical landscaping company, Greenline Landscaping: a crew of four, about $520,000 a year in revenue. Residential clients pay on completion; commercial clients pay 30 days after the invoice. Here is its April counted both ways:

The accrual column counts the $48,000 Greenline billed and the $12,000 of materials that went into April jobs. The cash column counts the $29,000 that actually arrived ($20,000 from residential clients and $9,000 from March's commercial invoices) and all $16,000 of materials bought, including $4,000 stocked for May.

The $23,000 difference between the two profits is exactly those two timing items: $19,000 of billing not yet collected plus $4,000 of materials bought ahead. It's the same business and the same month.

Some things are identical under both methods. The $7,000 mower Greenline bought in April is equipment, so both sets of books spread its cost over its working life rather than expensing it at once. The $1,500 of truck-loan principal and the owner's $4,000 draw aren't expenses in either. That's why even cash books don't match the change in the bank balance exactly (see Profit Is Not Cash for the full walk).

Which One Tells the Truth About April?

Both do, about different things.

The accrual view says April's work was profitable: Greenline charged enough to cover its crew, materials and overhead with $10,000 left. That's the number to use when you ask whether prices are right or whether a service line pays.

The cash view says April drained $13,000 from running the business. That's the number to use when you ask whether you can make payroll in May.

The cash view also distorts the following months. In May, those $28,000 of April commercial invoices arrive and count as May revenue on cash books, so May looks stronger than the work done in May. In a seasonal business the effect repeats every fall: October's commercial work gets paid in November, and November's cash books make a slow month look busy.

How Do I Tell Which Basis My Reports Use?

Four quick checks, roughly in order of speed:

1. Read the report header or footer. Many accounting programs print "Cash Basis" or "Accrual Basis" on every report, and most let you run the same report either way.
2. Look at the balance sheet. Accounts receivable or accounts payable with real balances means accrual. A cash-basis balance sheet usually shows neither.
3. Compare revenue to deposits. If a month's revenue equals the customer payments that hit the bank, you're on cash. If it equals what you invoiced, you're on accrual.
4. Ask who set it up. Many bookkeepers keep accrual books for management reports while the tax return is prepared on a cash basis. It's common to have both.

A lot of small businesses end up on a mix, sometimes called modified cash: revenue counted when collected, but equipment recorded as an asset and depreciated. That's workable, as long as you know which items follow which rule.

Which Should a Small Business Use?

For taxes, most small businesses under an IRS size test can choose the cash method, and many do because it defers tax on money not yet collected. Larger businesses, and some with inventory, must use accrual. Switching methods for taxes generally needs IRS approval (Form 3115), so it's a decision to make with your CPA, not mid-year.

For running the business, the answer is usually accrual, or at least an accrual view of your numbers. Pricing, gross margin by service and the question of whether a month's work paid all need revenue and costs matched to the same month. Keep the cash view alongside it for the bank.

What to Look For

• A basis that changes between reports. Comparing a cash-basis month to an accrual-basis plan will show a gap that isn't real. Check both use the same basis before reading the difference.
• Big receivables on "cash" books. If the balance sheet shows receivables but revenue follows deposits, the books are a mix, and margins by month will be unreliable.
• Seasonal swings that look too good. On cash books, the first slow month after peak often looks strong because last month's invoices are landing. Judge it by the work done.

What a Finance Consultant Would Do Next

A consultant looking at Greenline would put its books on one basis before drawing conclusions, use the accrual view to judge which services carry the margin, and use the cash view to plan the spring, when commercial billing jumps a month before the money does.

That analysis is what Occam's Model runs on your own books. It reads the spreadsheet exports you already have, asks a few questions where something is unclear, and lays out the path from revenue down to cash, so you can see where profit and the bank balance part ways. It doesn't ask which basis your books use, so know yours before you read the results. When you need extra help, an expert can review it with you.

Common Questions

What is the main difference between cash and accrual accounting?
Timing. Cash accounting records income and costs when money moves. Accrual accounting records them when the work is done and the costs are used, whatever the payment date.

Can I use cash accounting for taxes and accrual for my own reports?
Many small businesses do. The tax return follows the method you've chosen with the IRS, and your management reports can follow another. Ask your CPA how your books reconcile the two.

Why does my profit change when I switch a report from cash to accrual?
Because unpaid invoices, unpaid bills and stock bought ahead are counted in different months. The difference between the two profits equals the change in those balances over the period.

Which method is better for a seasonal business?
Accrual for judging each month's work, cash for planning the bank balance through the slow months. Cash books alone make the first month after peak look better than it was.