Cash vs Accrual Accounting: Which is best for Online Entrepreneurs?

Accounting is an integral part of every business, and when you’re selling a business it’s often the single most important piece of information presented to any potential buyers.

Accounting is the process of recording financial transactions and analyzing financial reports to help business owners make informed decisions. Every business owner must choose the method of accounting that best suits their business needs. Two popular methods of accounting are the cash basis of accounting and the accrual basis of accounting.

In this guide, we will explain what cash accounting is, what accrual accounting is, the advantages and disadvantages of each method, and whether a small online business should use the cash method or accrual accounting method.

What is Cash Basis Accounting?

The cash basis method of accounting is a method where income and expenses are recorded on a company’s financial statements only when the money changes hands. This means that revenues are recorded when cash is received, and expenses are recorded when they are paid.

The cash method of accounting is a straightforward and easy method that is often used by small businesses such as sole proprietors, partnerships, and LLCs.

For example, if you own a small online business and receive payment from a customer, the money is recorded as income only when it is received. Likewise, if you pay for your website hosting, the expense is recorded only when the payment is made.

What is Accrual Basis Accounting?

The accrual accounting method records income and expenses when they are earned or incurred, not just when cash changes hands.

In other words, income is recorded when it is earned, even if it has not been received, and expenses are recorded when they are incurred, even if they have not been paid. The accrual method of accounting provides a more accurate picture of the financial health of a business, and is often used by larger businesses with more complex financial transactions.

The accrual method works best when accepting or making credit card payments. For example, if your small online business sells products on credit, the sale is recorded as income even though the payment has not been received. Cash payments can be accounted for fairly quickly, but it takes time for credit-based statements to arrive, so if you are not using the the accrual based method these would not be counted until received. 

Alternatively, if you receive an invoice for website hosting but do not pay it until the following month, the expense is still recorded in the current month.

Cash vs Accrual Accounting?

Pros and Cons of Cash Accounting

Advantages of cash basis accounting:

• Simple and straightforward: Cash based accounting is simple and straightforward, making it easy for small business owners to understand and use.
• Clearer picture of cash flow: As revenue and expenses are tracked as cash exchanges hands, it often provides an accurate picture of the cash flow of a business.
• Less costly: Due to the simplicity of cash accounting, it is less costly than accrual accounting. It also gives you the opportunity to take advantage of significant tax breaks by timing your transactions, allowing you to legally lower your tax liabilities at certain times.

Disadvantages of cash basis accounting:

• Misleading financial reporting: The financial performance of a business may not be accurate as a result of a business owner holding off on paying bills for a particular period of time despite having incurred those expenses. While this can be better for personal reporting rather than assessment from a bank or potential investor, it also means the system is easier to manipulate.
• Compliance: Cash basis accounting is not acceptable under the Generally Acceptable Accounting Principles (GAAP), or the International Financial Reporting Standards (IFRS), which may be an issue when dealing with external stakeholders such as lenders or investors. Regulated and publicly traded businesses must adhere to GAAP, and many private companies choose to comply with these standards to provide transparency.
• Inventory management: Cash based accounting teats inventory as an expense, and it does not become an asset until it is sold for cash. This can mean It may also be misleading for businesses that have high levels of accounts receivable or accounts payable, as it does not reflect the amounts owed or owing to the business.

Pros and Cons of Accrual Accounting

Advantages of accrual based accounting:

• Complete picture of financial performance: The business records income and expenses when they are earned or incurred in a certain time period, correlating sales and expenses in that same period of time.
• GAAP compliant: Accrual accounting is in compliance with GAAP, making it more acceptable to external stakeholders.
• Informed decision making: Lastly, it provides a better picture of the profitability of a company in a particular period, allowing for informed decision-making.

Disadvantages of accrual accounting:

• More complicated: Accrual basis accounting is more complicated and may be more difficult for small business owners to understand and use. Therefore it may require more time and resources to implement due to the complex nature of financial records.
• Cash flow inaccuracies: Due to the possibilities of revenues being recorded even though they have not been received, accrual basis accounting may not provide an accurate picture of the cash flow of a business.

Should a Small Online Business Use Cash or Accrual Accounting?

Deciding whether to use cash or accrual accounting depends on the nature and size of your business.

As a small online business, you may find that the cash method is adequate for your needs. If your business is straightforward, with relatively few transactions, and you do not extend credit to your customers, then cash basis accounting may be the best option for you. It is less complicated, easier to understand, and less expensive than the accrual method. Additionally, as a small business, cash flow is often more important than profitability, and cash accounting method provides an accurate picture of the cash flow of your business.

Alternatively, if your business is more complex with numerous transactions, extending credit to customers, and dealing with accounts receivable and accounts payable, then accrual basis accounting may be a better option. It provides a more accurate picture of the financial health of your business and allows for better decision-making. Additionally, if you plan on expanding your business, or if you need to comply with GAAP,  then accrual accounting is a better option.

Conclusion

In conclusion, accounting is an important part of every business, and choosing the right accounting method is crucial for the financial health of your business. Cash method and accrual method accounting are two popular methods of accounting, with both having their advantages and disadvantages.

As a small online business, you must determine which method best suits your needs. If your business is straightforward, with few transactions and no credit extended to customers, then cash basis accounting may suit your needs.

However, if your business is more complex, with numerous transactions and extending credit to customers, then accrual accounting may be a better option. Ultimately, the goal is to choose the method that provides the most accurate picture of your business’s financial health and allows for informed decision-making.