There are two ways that accountants and business owners maintain their books: cash accounting vs accrual accounting. The time when income and expenses are recorded is the key distinction between accrual and cash basis accounting. While the accrual approach focuses on predicted revenue and expenses, the cash method offers instantaneous acknowledgment of revenue and expenses.
The majority of businesses should adopt accrual accounting. It is more accurate, and if you manage inventory, the IRS requires you to use it. When using a cash-basis accounting system, transactions are not recorded until actual cash is transferred out of or deposited into an account. Sole entrepreneurs and smaller enterprises are more likely to utilize the cash basis method.
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Revenue is accounted for when earned under the accrual accounting system. In contrast to the cash method, the accrual method captures revenue when a product or service is supplied to a customer with the anticipation of future payment. To put it another way, money is accounted for before receiving it. Similarly, costs for products and services are documented before any money is paid.
The accrual accounting approach does not require you to wait until cash changes hands before recording financial transactions. Instead, you record them in real-time. If a client’s order results in specific expenses on your end, you record the revenue as soon as the invoice is sent and the expenses as soon as they occur.
Revenue is recognized on the income statement only when cash is received under the cash basis accounting system. Expenses are only documented when cash is paid out. Small businesses and individuals usually use cash as a payment method. The cash-basis accounting approach is the most straightforward of the two accounting procedures. You record financial transactions using this approach when cash enters or exits your account. You don’t record project income until a customer pays you. Similarly, you don’t record a bill deduction until the creditor approves your payment.
Also Read: How Overhead Cost Affects Your Business
The Difference Between Accrual Accounting vs Cash Basis Accounting
Cash-basis accounting tracks revenue and expenses when actual payments are received or dispersed. It makes no allowance for when the transactions that generate them take place. In contrast, accrual accounting records revenue and expenses as they occur before any money is received or paid out.
Accrual accounting is a system of accounting in which revenue and expenses are recorded before payments are received or distributed. In other words, it records revenue whenever a sale is made. When a transaction to purchase goods or services occurs, it records expenses. A corporation accounts for revenue only when it gets paid for the products or services it provides to clients using the cash basis accounting technique.
Key Difference Between Accrual Accounting vs Cash Basis Accounting
There are key differences between accrual accounting vs cash basis accounting that you can use to differentiate between them. Here they are:
1. Accrual Method
By keeping track of both receivables and payables, the accrual method gives a more realistic view of a business’s financial health, especially over the long term. For instance, if a business uses the cash method of accounting, the business wouldn’t include the current quarter’s revenues in the company’s financial statements. The subsequent quarter is projected to include the corresponding revenue. An investor can get the wrong impression about the company’s profitability when, in fact, the business is doing rather well.
The accrual method does not account for cash flow. A corporation may appear successful in the long run but has a difficult, significant financial shortage in the near run. Another disadvantage of the accrual approach is that it might be more difficult to utilize because it requires accounting for unearned revenue and prepaid expenses. It may also necessitate the hiring of additional personnel. The accrual method is typically required for companies that file audited financial statements. It is accepted under the generally accepted accounting principles (GAAP) issued by the Financial Accounting Standards Boards (FASB).
2. Cash Basis Method
The cash method’s main virtue is its simplicity—it merely tracks cash paid or received. It is also simpler to track a company’s cash flow. It is advantageous to sole proprietorships and small firms because it won’t require more staff (and the associated costs). However, the cash basis method may overestimate the health of a cash-rich corporation. This method is because it does not record accounts payables that may exceed the cash on hand and the company’s current revenue stream. As a result, an investor may believe that the company is profitable when, in fact, the company is experiencing financial troubles. GAAP does not permit the cash basis method.
Accrual Basis Pros and Cons
Rather than focusing on the precise time a transaction occurred, accrual focuses on what you earned and owned in a particular period. This type of data provides you (and other stakeholders such as shareholders or creditors such as banks) with a greater insight into long-term business patterns, not to mention your company’s overall profitability. However, because the accrual technique does not maintain a rigorous track of your cash flow, you are responsible for this responsibility.
After all, if your accounts receivable exceed your invoices paid, you may find yourself spending money you don’t have. If you utilize the accrual bookkeeping system, you will want to create accurate cash flow statements regularly so you can make informed decisions about when and how to spend your (real) money. The accrual technique could cause problems with your taxes.
Here are the pros and cons of accrual basis accounting:
- More accurate long-term financial health image
- A better description of current assets and liabilities
- Possibility of having to pay income taxes on unearned income
- There is less certainty about the immediate cash flow.
Cash Basis Pros and Cons
The cash method of accounting appears rational until you consider that many business owners complete all of the work for a project months before being paid. For example, suppose you pay for a project’s expenses in July but don’t record any money until October. In that case, July appears to be extremely unsuccessful, while October appears to tremendously successful—and that’s not a realistic picture of your company’s long-term financial health and stability.
And, while cash-basis accounting might provide a snapshot of how much cash you have on hand at any particular time, it does not account for bills that have accrued but have not yet paid. One month may appear to be more profitable than it is since you have not paid off any expenses incurred throughout the month. Since income is not counted until it is received, tax time can less stressful because you will only taxed on money you have.
Here are the pros and cons of cash basis accounting:
- Short-term financial snapshot
- The method that requires less time and effort to master
- Easy analysis of current cash flow
- Misrepresentation of business trends over the long run.
- Lack of compliance with GAAP (generally accepted accounting principles)
Thus, the time when income and expenses are recorded is the key distinction between accrual and cash basis accounting. While the accrual approach focuses on predicted revenue and expenses, the cash method offers instantaneous acknowledgment of revenue and expenses. Cash-based accounting tracks revenue and expenses when actual payments are received or dispersed. It makes no allowance for when the transactions that generate them take place. In contrast, accrual accounting records revenue and expenses as they occur before any money is received or paid out.
There are pros and cons of cash basis accounting vs accrual basis of accounting. You can use Accounting Software to help with company bookkeeping, so you don’t have to bother doing manual bookkeeping. Get full-featured accounting software from HashMicro with powerful financial management tools, including cash flow management, journal entries, and reconciliation. To facilitate your company’s accounting, you can also view the pricing scheme calculations for the HashMicro Accounting Software. Also, you can try our free demo Accounting Software!