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Cash vs Accrual Method of Accounting: What is the difference?

It’s all in the timing. If you record income and expenses on a cash flow basis, i.e. the date that the money changes hands, you are using a cash method of accounting. If you record income at the time that the services are rendered, i.e. earned, then you are using an accrual method of accounting.

So, for example, if you pay your rent annually and record it on the day you pay it, you are using the cash method. If you record it in 12 transactions, one each month, you are using an accrual method to account for the expense.

As you can guess, the accrual method is a bit more complicated, so why would you want to use it? If you record income and expenses in the time-frame that they incur, then you can tell whether the income you earned in a given time-frame covered the expenses that you had for that time-frame. Here’s an example.

Say you have the following income and expenses in June:

Income
Client Fees collected during June $12,000
Expenses
Annual Rent $12,000
Utilities for June $200
Car Insurance bi-annual payment $500
Office Insurance annual payment $1,000
Office Expenses for June $250
Website Hosting for year $300
Telephone Expense for June $70
Total Expenses $14,320
Total Profit/Loss (?) ($2,320)

At first glance (with this cash method of accounting), it looks like you had expenses of $14,320 and only made $12,000 in income giving you a deficit of $2,320 for the month.

But if you used the accrual method of accounting, it would be much easier to see that not only are the Rent, Car Insurance, Office Insurance and Web Hosting expenses for more than just the month of June but that your collected Fees were actually for the previous month. Allocating these figures to the month they are incurred shows that you actually had a surplus of earned income over expenses of $8,288 for the month of June.

Here’s how I got that:

Income
Client Fees earned in June $10,000
Expenses
Rent for June = $12,000/12 $1,000
Utilities for June $200
Car Insurance for June = $500/6 $83.33
Office Insurance for June = $1,000/12 $83.33
Office Expenses for June $250
Website Hosting for June = $300/12 $25
Telephone Expense for June $70
Total Expenses for June $1,711.66
Total Profit for June  $8,288.33

You can see how this combination of monthly, bi-annual and annual payments makes it hard to really get a handle on how your business is actually doing at any given time. Add in the fact that your clients may pay you at irregular intervals and for Fees earned in the previous month and it gets even more complicated.

Hence, whether you use the cash method of accounting or the accrual method of accounting dictates the timing of your reporting and can illuminate whether your business is earning enough to cover your expenses. Being aware of these issues is the first step towards successful planning.

Next time, I will go over some accounting terms including some of the terms I used in this tip.

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