Cash or Accrual Bookkeeping: Which One Shows a Small Business the Truth

A furniture maker has the best December in years: twelve large orders delivered. The owner looks at the bank account in early January and sees less money than in November. On the bank statement, December looks like a bad month. In reality it was the most profitable of the year: the customers simply pay in January and February, while timber and wages were paid in December. Whether you keep cash or accrual bookkeeping decides which of those two stories your reports tell.

Two ways of deciding "when"

Both methods record the same transactions. They differ in the date.

Cash basis. Income is recorded on the day money arrives. An expense is recorded on the day money leaves.

Accrual basis. Income is recorded when it is earned: when the goods are delivered or the service performed, usually the invoice date. An expense is recorded when it is incurred: when you receive the goods or use the service, usually the bill date.

Under accrual, unpaid customer invoices appear as receivables, and unpaid supplier bills appear as payables. Under cash basis, neither exists in the books until money moves.

One month, two results

A small business in December:

• Delivers and invoices goods worth 100 million. Customers pay 40 million in December and will pay 60 million in January.
• Receives 30 million from customers for November invoices.
• Buys materials worth 50 million, pays 20 million now and 30 million in January.
• Pays wages of 25 million.
• Pays 12 million for a year of insurance covering January to December next year.

Cash basis, December:

• Money in: 40 + 30 = 70 million.
• Money out: 20 + 25 + 12 = 57 million.
• Result: 13 million.

Accrual basis, December:

• Income earned: 100 million.
• Materials used: assume all 50 million went into the goods delivered.
• Wages: 25 million.
• Insurance: nothing, because it covers next year.
• Result: 25 million.

Same business, same month: 13 million or 25 million. Neither is wrong. They answer different questions. Cash basis answers "how did the bank balance change?" Accrual answers "how much did we earn from this month's work?"

What cash basis is good for

• Simplicity. If you can read a bank statement, you can keep cash books.
• It matches the bank. No reconciliation between profit and cash.
• It suits immediate-payment businesses. A food stall, a small shop with no credit sales, a freelancer paid on delivery.

Its weaknesses:

• Profit swings with payment timing. A late-paying customer makes a good month look bad and the next month look good.
• No view of who owes you or whom you owe. Receivables and payables are invisible.
• Prepayments distort. A year of rent paid in one month looks like a terrible month.
• Stock is invisible. Buying inventory looks like an expense even though the goods are still on the shelf.

What accrual is good for

• True monthly performance. Income is matched with the costs of earning it.
• Receivables and payables are tracked. You can see who has not paid and what is due.
• Margins make sense. Cost of goods is recorded when the goods are sold, not when bought.
• Comparison between months is meaningful.
• Lenders and investors expect it.

Its weaknesses:

• More work. Invoices and bills must be recorded when issued or received, and again when paid.
• Profit is not cash. A business can show a healthy profit and run out of money, because the profit is sitting in unpaid invoices.
• Needs judgement at period end: accruals, prepayments, stock.

The danger on each side

On cash basis: thinking you are doing badly, or well, because of payment timing. Decisions about pricing and hiring get made on noise.

On accrual: thinking profit means money. The furniture maker under accrual sees a splendid December and must still find wages in January before the customers pay.

The remedy for the second is not to abandon accrual. It is to watch cash as well.

Which should you use

As a rule of thumb: the day you send your first invoice with payment terms, cash basis stops telling you the truth.

Separately from what is useful for management, official reporting has its own rules. Tax law and accounting standards in each country say which methods are permitted for which businesses. Take advice before deciding how your statutory books are kept.

The practical answer: accrual books plus a cash view

Most growing small businesses do best with both:

• Accrual books for profit, margins, receivables and payables.
• A cash flow view alongside: a weekly look at the bank balance, what is expected in and what must go out.

Read them together each month. Ask two questions: did we earn a profit, and did that profit turn into cash? When the answers differ, the reason is in receivables, payables or stock, and that is where to act.

Moving from cash to accrual

Pick a start date, ideally the first day of a financial year or at least of a month.

1. List what customers owe you on that date: every unpaid invoice. This is your opening receivables.
2. List what you owe suppliers: every unpaid bill. Opening payables.
3. Count stock and value it at cost. Opening inventory.
4. List prepayments and deposits: rent or insurance paid ahead, deposits you hold from customers.
5. From the start date, record by document date. Sales when invoiced, purchases when billed, then payments against them.

Have an accountant review the opening balances. Errors there follow you for years.

Expect the first months to feel like more work. The return comes the first time you can answer "who owes us money and how old is it?" in ten seconds.

Month-end on accrual, briefly

• Invoice everything delivered in the month.
• Record all supplier bills dated in the month, and estimate any not yet received.
• Spread prepaid costs: one twelfth of annual insurance each month.
• Adjust stock if you count it monthly.
• Reconcile the bank.

These five habits make accrual figures reliable.

Common mistakes

• Mixing the methods without knowing it. Sales recorded when invoiced, expenses when paid. The result means nothing.
• Treating a customer deposit as income before the work is done.
• Expensing a whole year of rent in one month.
• Recording stock purchases as cost of goods sold at the time of buying.
• Ignoring receivables because "it is in the books as income". Income that is never collected is a loss waiting to be recognised.
• Judging the business by the bank balance alone.

Tools

Accrual by hand in a spreadsheet is possible and tedious. Bookkeeping software handles it naturally: an invoice creates a receivable, a payment clears it, and reports can be drawn either way. Polynusa's bookkeeping records invoices, bills and payments in one workspace with the sales records they come from. See the pricing page.

Summary

Cash basis records money when it moves, and accrual records income when earned and costs when incurred. Cash basis is simple and suits businesses paid at once. Accrual shows true monthly profit and is needed once you sell or buy on credit, hold stock or run long projects. Keep accrual books and a cash view side by side, set opening balances carefully when you switch, and check the rules for official reporting with an accountant.

FAQ

What is the difference between cash and accrual bookkeeping?

Cash basis records income when money is received and expenses when money is paid. Accrual basis records income when it is earned, such as when goods are delivered or an invoice is issued, and expenses when they are incurred, whether or not money has moved yet. The difference is timing.

Which method is better for a small business?

A very small business that is paid immediately and holds little stock can manage on cash basis. Once you sell on credit, buy on credit, hold meaningful stock or want to know true monthly profit, accrual gives a more accurate picture. Many small businesses keep accrual books and watch cash separately.

Can a business choose freely which method to use for tax?

Not always. Tax rules and reporting standards in each country set out which methods are allowed for which kinds of business, and what must be done when changing. Ask a qualified accountant where you operate before choosing or changing a method for official reporting.