Cash vs. Accrual Accounting: What is the Difference?

Blog / Accounting

Cash vs. Accrual Accounting: What is the Difference?

As a small business owner, there are two accounting methods you can use to set up and manage your bookkeeping: cash accounting and accrual accounting.

There’s a big difference between the two when it comes to recording revenue and expenses. Choosing the right method of accounting will ensure you meet your reporting obligations and help you manage your company's financial health.

Breaking Down Cash vs. Accrual Accounting

The key difference between cash and accrual accounting is when your revenues and expenses get recognized:

  • Cash accounting recognizes revenues and expenses when the money changes hands
  • Accrual accounting recognizes revenues and expenses when the transaction happens
differences between cash and accrual accounting

Cash Basis Accounting

Cash accounting recognizes revenue when you receive payment for a sale, and expenses (and prepaid expenses) when you pay for a purchase. It’s easy to determine when a transaction took place – you just look at when the money entered or left your bank account. 

Many business owners prefer cash accounting because they don’t have to track accounts receivable or accounts payable.

But while cash accounting provides an accurate picture of how much money you have right now, it doesn’t accurately reflect your financial state in the long term. And that can lead to understated expenses or overstated income.

Here’s an example:

John had a bad sales month in January and performed only two landscaping jobs. That same month, he received $4000 in past due payments for jobs he performed in November. Using cash basis accounting, John’s books would show his business did well in January when in reality he did not.

Accrual Basis Accounting

Accrual accounting recognizes revenue when you deliver a service or product, and expenses when you incur them. Accrual accounting is more complicated than cash accounting because you have to keep track of invoices – not just your bank accounts.

Accrual accounting gives you a realistic picture of your business’s financial health because it better matches the timing between revenues and expenses. As a result, it can help you:

  • Clearly see upcoming expenses and income and expenses for past periods
  • Identify income trends and customer spending habits
  • Create cash flow forecasts to better manage working capital during slow periods and resources during peak periods

It’s also important to note that lenders and investors will typically look for financial statements based on accrual accounting. 

Recording Cash vs. Accrual Accounting Transactions

Revenues and expenses are recorded differently in cash vs. accrual accounting. Here are some quick examples.

Recording Revenues

John performed a landscaping job on 20 November 2019 and received payment on 4 January 2020:

  • Using cash accounting, John would record the revenue on 4 January 2020 (the day he received the payment)
  • Using accrual accounting, John would record the revenue on 20 November 2019 (the day he performed the job)

Recording Expenses

John purchased 5 boxes of fertilizer on 4 December 2019 and paid his supplier on 3 January 2020:

  • Using cash accounting, John would record the expense on 3 January 2020 (the day he paid his supplier)
  • Using accrual accounting, John would record the expense on 4 December 2019 (the day he purchased the fertilizer)

Income Tax Considerations

Income taxes also play out differently in cash vs. accrual accounting:

  • In cash accounting, your business income is taxed when the money enters your bank account
  • In accrual accounting, your business income can get taxed before you even receive it

For example, if you send out invoices toward the end of the year, they might not get paid until the new year. But since accrual accounting says you record revenue when sales happen, you must include that income in your year-end tax accounting. 

Here’s an example:

John performed a landscaping job on 20 November 2019 and received payment on 4 January 2020:

  • Using cash accounting, John would record the revenue on 4 January 2020 (the day he received the payment) and report it as 2020 income
  • Using accrual accounting, John would record the revenue on 20 November 2019 (the day he performed the job), report it as 2019 income, and pay taxes accordingly

On the upside, because expenses are recognized when they’re incurred in accrual accounting, if you receive an invoice late in the year but don’t pay the bill until the new year, you can still deduct that expense when reporting your year-end income. 

Choosing the Right Accounting Method

Most small businesses in Canada are required to use accrual accounting to report their income to the Canada Revenue Agency (CRA) and to prepare their financial statements in accordance with ASPE (accounting standards for private enterprises).

However, if you’re a farmer, fisher, or self-employed commission agent, you can choose either cash or accrual accounting, so long as you:

  • Use accrual accounting for any separate business activities
  • Use accrual accounting for GST/HST/QST purposes
  • Keep separate bookkeeping records for each accounting method you use

It’s best in every case to consult your accountant before choosing your accounting method. Keeping your books up to date, meanwhile, will ensure you don’t scramble come tax time.

If you’re uncertain as to how to get your books in order and keep them that way, Enkel’s experienced team of accountants and bookkeepers can help.

Contact us today for more information.

Gracia Chua
About Gracia Chua
Gracia Chua is the Marketing Specialist at Enkel Backoffice Solutions, a Vancouver based accounting firm that provides day-to-day bookkeeping services for small to medium-sized businesses and non-profit organizations.