Cash vs. Accrual Accounting
The first major judgment decision every business makes. When do you recognize revenue and expenses? The answer changes everything.
Why This Matters
A business owner receives a $100,000 contract. Great news, right?
But then she has to decide: "Do I record this as income now, or when I actually deliver the work?"
That decision changes everything:
Understanding cash vs. accrual accounting is understanding how businesses manipulate—or accurately present—their financial reality.
The Fundamental Difference
Cash Basis
Record it when cash moves
Customer pays you $1,000
→ Record $1,000 revenue (right now)
Your financial statements show only actual cash transactions. Simple, but potentially misleading.
Accrual Basis
Record it when the economic event happens
Customer agrees to pay you $1,000
→ Record $1,000 revenue (when earned)
Your financial statements show economic reality, not just cash reality. Complex, but accurate.
Cash Basis: Simple but Flawed
How Cash Basis Works
January: Customer prepays $5,000 for 12-month service
→ Record: $5,000 revenue in January
February through December: You provide the service
→ Record: Nothing (no cash moved)
December 31: Report shows $5,000 revenue this year
Reality: You provided 12 months of equal service
The problem: Your financial statements don't reflect reality. January looks like a monster revenue month when you actually earned it evenly across 12 months.
When Cash Basis Makes Sense
Cash basis accounting is simple and used by:
- Very small businesses (sole proprietor)
- Service businesses with immediate payment
- Businesses with no credit transactions
- Businesses that prefer simplicity over accuracy
Example: A plumber who bills and gets paid same day can use cash basis. The timing gap between work and payment is minimal.
The Cash Basis Problem
Year 1 (Cash Basis)
Jan 1: Customer pays $50,000 for 2-year project
Record: $50,000 revenue
Record: $0 expenses (work hasn't cost anything yet)
Net Income: $50,000 ✓
Year 2 (Cash Basis)
You do the work ($30,000 of costs incurred)
Record: $0 revenue (no cash received)
Record: $30,000 expenses
Net Income: ($30,000) ✗
Result: Year 1 looks wildly profitable, Year 2 looks like a loss.
Reality: You broke even—earned $50,000 revenue, spent $30,000.
This is why cash basis is banned for most businesses.
Accrual Basis: Complex but Accurate
How Accrual Basis Works
January: Customer agrees to pay you $5,000 for 12-month service
→ Record: (nothing yet—agreement isn't the same as earning)
January 31: You've provided 1/12 of the service
→ Record: $5,000 ÷ 12 = $416.67 revenue
February 28: You've provided another month
→ Record: $416.67 revenue
(Repeat each month)
December 31: You've provided 12/12 of the service
→ Total recorded: $5,000 revenue over the year
Reality: Matches what actually happened
Why GAAP Requires Accrual Accounting
Matching Principle
Match revenues to the period earned
Completeness
Show full economic picture
Comparability
All companies report same way
Usefulness
Statements reflect reality
Fraud Prevention
Harder to manipulate
The Real-World Gap
See how the two methods can produce dramatically different results for the same business.
Key Recognition Rules (Accrual Basis)
Revenue Recognition
Recognized when:
- Performance obligation is satisfied (you've earned it)
- Payment is probable (customer will likely pay)
- Price is measurable (you know what you'll get)
NOT when:
- Customer promises to pay (only when you've performed)
- Payment is received (accrual records when earned)
- You invoice the customer (only when work is done)
Expense Recognition
Recognized when:
- You incur the obligation (you owe it)
- Cost is measurable (you know what you owe)
- Related to revenue (if tied to a sale)
NOT when:
- You pay the bill (accrual records when incurred)
- You order something (accrual records when received)
- You estimate future costs (only when certain)
Tax Implications
Cash Basis Tax Advantage
Cash received: $100,000
Cash paid: ($40,000)
Taxable income: $60,000
Tax benefit: You can reduce taxable income by timing when you bill customers and pay bills. Defer revenue by not billing until year-end.
Accrual Basis Less Flexible
Revenue earned: $100,000 (even if not collected)
Expenses incurred: ($40,000)
Taxable income: $60,000
Less tax flexibility, but more accurate. Can't manipulate by timing cash. You pay tax on what you've earned.
Tax law: Most businesses with over $29 million in sales must use accrual basis for tax purposes (IRS requirement).
Who Uses Each Method?
Cash Basis Typically Used By
- Sole proprietors (if < $29M revenue)
- Service businesses with immediate payment
- Farmers and ranchers
- Businesses with minimal inventory
- Tax-minimization strategies (when allowed)
Accrual Basis Required By
- Most corporations
- Public companies (GAAP requirement)
- Businesses with inventory
- Partnerships (if partners are corporations)
- Businesses with > $29M revenue (IRS)
The Accounting Quality Issue
Accrual accounting enables accuracy, but also enables fraud.
Cash Basis: Hard to Manipulate
"We sold $X and customers paid $Y. That's fact."
Accrual Basis: Easy to Manipulate
"We earned $X (even if not paid). We estimate we'll collect it."
"We can recognize this revenue even though contract is unsigned."
→ This is where fraud happens
This is why auditors focus on revenue recognition—it's the #1 manipulation area.
Key Takeaway
Cash basis accounting records only actual cash movements, while accrual basis records economic events (revenue when earned, expenses when incurred). Though cash basis is simpler, accrual basis is required by GAAP for most businesses because it reflects economic reality more accurately. Understanding when to recognize revenue and expenses—and why—is essential to reading financial statements and detecting potential fraud.
Test Your Understanding
Which basis of accounting is required by GAAP?
A customer pays you $12,000 upfront for a 12-month service contract. Under accrual accounting, when do you record revenue?
A contractor completes 60% of a $100,000 contract this year but will receive no cash until next year. Under accrual accounting, what revenue is recorded this year?
True or False: Cash basis accounting is simpler but less accurate than accrual basis.
A business uses cash basis accounting. It receives a $50,000 prepayment in December for work to be done in January-March. When does it record the revenue?
Ready to Practice?
You now understand the foundational choice every business makes: cash or accrual. Practice identifying which basis applies and converting between methods.
Try the Practice Lab