Cash vs Accrual Accounting: What Small Businesses Should Know

The two methods differ in one way: timing. Both end up recording the same total once every invoice has been paid. What changes is the month in which each amount appears.

Cash basis is simple and follows the bank statement closely. Accrual basis needs more work: tracking receivables and payables, estimating unbilled costs, and spreading prepaid amounts. That extra work is what makes each month comparable with the next.

Most small businesses sell on credit, buy on credit, pay some costs in advance and receive some bills late. On a cash basis, any of these can push income or costs into the wrong month. One large collection can make a weak month look strong. A quarterly rent payment can make one month look like a loss and the next two look unusually profitable.

Accruals fix this by matching. Income goes in the month it was earned, and the costs of earning it go in the same month. This makes margins, budget-versus-actual reviews and month-on-month trends meaningful. Cash still matters, but you track it separately, through a cash position worksheet and the bank reconciliation, not through the profit figure.

Take an illustrative service business in one month. All figures are illustrative and do not describe a real business.

• Invoiced Rs 5,00,000 for work completed this month; Rs 3,00,000 was collected this month.
• Collected Rs 1,50,000 for work invoiced and completed last month.
• Received a Rs 1,00,000 advance for work to be done next month.
• Paid salaries of Rs 2,00,000 for this month.
• Paid Rs 1,20,000 rent covering this month and the next two months.
• Received a contractor bill of Rs 60,000 for this month's work, to be paid next month.
• Used about Rs 15,000 of electricity this month; the bill has not arrived.

On a cash basis, income of Rs 5,50,000 is everything that came in: Rs 3,00,000 plus Rs 1,50,000 plus the Rs 1,00,000 advance. That figure includes last month's work and next month's work. On an accrual basis, income is the Rs 5,00,000 earned this month. The unpaid Rs 2,00,000 sits in receivables, and the advance is held as a liability until the work is done.

On the cost side, accrual accounting charges one month of rent, Rs 40,000, and carries Rs 80,000 as a prepaid expense. It records the contractor bill as a payable and accrues an estimated Rs 15,000 for electricity. The cash view shows Rs 45,000 more profit than the work actually earned. Next month the cash view could swing the other way.

1. Raise sales invoices for all work completed or goods delivered by month-end, and list any work done but not yet billed.
2. Separate customer advances from earned income and track them against later invoices.
3. Enter supplier bills dated in the month, including those received in the first days of the next month that relate to it.
4. Estimate costs incurred but not yet billed, such as utilities, professional fees or interest, and record them in an accrued expenses schedule with the basis of each estimate.
5. Spread prepaid costs such as rent, insurance and subscriptions over the months they cover, using a prepaid expenses schedule.
6. Reverse or replace last month's estimates once the actual bills arrive, and investigate large differences.
7. Review receivables and payables ageing so that what you recorded is still collectible or still owed.

These steps fit into the month-end close checklist guide. The accrued expenses supporting schedule guide explains how to document each estimate so that a reviewer can follow it.

• Treating bank receipts as sales, so that customer advances and old collections inflate the month.
• Booking supplier bills only when paid, which hides costs already incurred.
• Expensing annual or quarterly payments in the month paid.
• Making accrual estimates with no written basis, so no one can check them later.
• Forgetting to reverse last month's accruals, which counts the same cost twice.
• Switching between methods from month to month, which makes trends meaningless.
• Reading accrual profit as available cash and making payment decisions from it.

A very small business that is paid on the spot, buys on the spot and has few advance or late-billed costs may see little difference between the two methods in a given month. Some owners also keep a simple cash view for day-to-day decisions alongside accrual accounts.

This guide does not cover which accounting method the law requires for your type of entity, or how it affects tax computation. Those rules depend on your business structure and circumstances. Check them with your chartered accountant before choosing or changing the method for your statutory books.