Cash vs. accrual accounting: How are you recording revenue and expenses?

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Different ways to track funds.

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How much income did your small business make last year? That answer could vary greatly depending on the type of accounting you use to keep your books. Small companies often keep cash basis books, which look like your checking account—cash in and cash out. But corporations—especially those that are publicly traded or otherwise regulated—use accrual accounting.

Understanding these two accounting methods will help you analyze your own financial situation and that of companies you’re considering as investments. The chief difference is in the recording of revenue and expenses on an income statement.

Cash basis is the method of tracking income and expenses by the cash that comes in compared to the cash going out. Some tax returns and most personal financial statements use the cash basis. Every dollar of cash that’s deposited into the business is considered income; every dollar used to pay for something (except paying off debt) is considered an expense.

Expenses paid with a credit card are typically considered cash basis expenses when they are incurred, not when they are paid off. So if a small business pays for some office supplies on its credit card, the transaction will show up right away as an office supplies expense, even if the credit card payment isn’t due for another month.

If you sell cupcakes as a home business and keep your books on the cash basis, your income statement might look like this.

Accrual basis is the general accounting method used by most companies in the U.S. The accrual method records income when goods or services are delivered to a customer, no matter when the customer pays. Accrual accounting also records an expense when the company gets a benefit from a purchase, even if it’s not yet paid for.

Recording revenue using accrual accounting can be tricky. If a product is handed to or shipped to the customer, revenue is recorded when the product is delivered. But if a service will extend over a period of time, the revenue should be recorded over that period of time, no matter when it’s paid for. Examples of services that extend over time might include:

Accrual-based expenses are a little easier to understand. Suppose a company rents its storefront for $2,000 a month. The lease starts on the first of the month, but the rent isn’t due until the fifteenth. As of the first of the month, the company knows it owes rent, so it would record a rent expense of $2,000 under the accrual method. (If the company keeps its books on a cash basis, they would not record the $2,000 rent expense until the fifteenth, when it’s actually paid.)

If you provide snow removal services as a home business and keep your books on the accrual basis, your income statement might look like this.

If someone owes you or a company money, it’s called “accounts receivable” (A/R) on the books. A/R is not recorded on the income statement, but rather on the balance sheet as an asset—that is, something owned. A/R is an asset because, at some point, the money will arrive in the form of cash (an asset).

Accounts payable (A/P) is created when you or a company received goods or a service but haven’t yet paid for it. Looking back at our rent example, the company owing rent at the first of the month would record “rent payable” even though they won’t pay cash for the rent until the fifteenth.

Generally accepted accounting principles (GAAP) is a standardized set of procedures and rules developed by the Financial Accounting Standards Board (FASB). These standardized rules make it easier for investors to read and compare the financial statements of different companies. GAAP mandates the use of the accrual basis and is required for companies that are regulated or publicly traded.

As an individual, your own “books” are typically kept on a cash basis. You need to make sure that you have the cash in your checking account in order to pay your bills. If you have a small business, you can choose to keep your books on the cash basis. As you sell items or services on credit and your business grows, you or your bank might need to document your revenue and expenses using accrual accounting. Accrual accounting provides a clearer picture of the health of a company because it considers expenses that might have been incurred but not paid, and revenue that has been earned but not collected.

As a small business owner, you should be cautious when using accrual accounting. If you look only at the revenue you have earned—but for which you haven’t received payment—you might have an inaccurate picture of how much cash is needed to pay your own bills.

And people who owe you money might not actually pay you. A financial statement showing $10,000 in accrual revenue but with $8,000 in A/R paints a much different picture than one showing $10,000 in cash basis revenue.

As you invest in other companies, look at their financial statements with an understanding of their accounting method. Accrual-based revenue should accurately reflect income that is earned, but be careful if the company has a large A/R balance that they may or may not collect.