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Accrual Accounting vs Cash Accounting

Accrual and cash basis are accounting methods of recording transactions. The time of recording these transactions is what differentiates the two methods. The biggest question, though, is which of these methods is ideal for your small business? 

 

Let’s find out. 

 

Cash Basis Accounting

The cash basis recognizes revenues when payments are received from customers/clients. This approach means transactions can stay unrecorded for days or weeks in circumstances where payment is delayed.

 

Pros And Cons Of Cash Basis

The cash basis method is simple to maintain because there’s no need to track account receivables and payables. It is easy to record when transactions occur by checking whether money is in or out of the bank. When using the cash basis method, it is easy to determine the amount of money at your disposal by looking at your bank balances. Entrepreneurs using cash basis accounting have a tax advantage since the business’s income is not taxed until it is in the bank.

 

The disadvantage of the cash basis method is that it can show that your business is profitable whereas you haven’t paid your bills. Such information can be misleading while making crucial business decisions. Another disadvantage of the cash basis is that it gives a day-to-day view of your finances instead of a long-term perspective hence it’s unreliable in making plans for the future. You cannot use cash basis accounting method if you have a big inventory. Therefore, big corporations with gross receipts need a more complex accounting system.

 

Related post: Understanding The Accounting Cycle For Your Small Business

 

Accrual and cash basis are accounting methods of recording transactions. The time of recording these transactions is what differentiates the two methods. The biggest question, though, is which of these methods is ideal for your small business? 

 

Let’s find out. 

 

Cash Basis Accounting

The cash basis recognizes revenues when payments are received from customers/clients. This approach means transactions can stay unrecorded for days or weeks in circumstances where payment is delayed.

 

Pros And Cons Of Cash Basis

The cash basis method is simple to maintain because there’s no need to track account receivables and payables. It is easy to record when transactions occur by checking whether money is in or out of the bank. When using the cash basis method, it is easy to determine the amount of money at your disposal by looking at your bank balances. Entrepreneurs using cash basis accounting have a tax advantage since the business’s income is not taxed until it is in the bank.

 

The disadvantage of the cash basis method is that it can show that your business is profitable whereas you haven’t paid your bills. Such information can be misleading while making crucial business decisions. Another disadvantage of the cash basis is that it gives a day-to-day view of your finances instead of a long-term perspective hence it’s unreliable in making plans for the future. You cannot use cash basis accounting method if you have a big inventory. Therefore, big corporations with gross receipts need a more complex accounting system.

 

The Accrual Basis Of Accounting

Under the accrual basis, transactions are recognized when they occur, meaning expenses are recorded when incurred and revenue recorded when earned. The accrual principle states that you should recognize financial events by matching revenues regardless of when payments are made.

 

Pros And Cons Of Accrual Basis

The advantage of the accrual basis method is that it gives a more accurate picture of a company’s profitability since it shows the account payables and receivables. Companies using the accrual basis method may seem unprofitable when they are profitable. For example, a company can have sales that have been recorded, but payment has not been received yet. This approach means the company is doing well even though the books show otherwise. 

 

The other advantage of accrual basis is that it provides more useful information for business analysis through business ratios. The method makes it easy to prepare net profit margin, return on equity, accounts payable turnover, working capital, and total debt to assets ratio. With expense and revenue matched, the financial statements represent business health rather than what is shown by the checkbook.

 

The disadvantage of the accrual basis is that it might not track cash flows hence it’s difficult to account for cash shortage in the short term. Therefore, a company can look profitable in the long term but with a cash shortage in the short term. For instance, with our previous example, your business could show you are profitable from billed customer transactions but your bank account is still zero if the customer is yet to pay the invoice. Because of this, you need to pay close attention to your cash flows. 

 

The other disadvantage of the accrual method is that it is complex and therefore hard to implement because you have to account for items like unearned revenue and prepaid expenses. More skills, time, and resources are required to implement the accrual method than the cash basis.

 

Example Of Cash And Accrual Basis Of Accounting

Suppose you own a business that sells cars. If a customer buys a car worth $20000 on a cash basis, that amount is not recorded in the books until you receive the cash payment or check. Under the accrual method, the $20000 is recorded in books as revenue immediately after making the sale, even if you will receive payment later.

 

The same concept applies to expenses. If you receive a water bill of $100 on a cash basis, the amount is not recorded until the bill is paid. However, under the accrual method, the $100 is recorded as an expense when you receive the bill.

 

Usage Of Cash And Accrual Basis: Which Method Is More Appropriate For Your Business?

Cash basis is the most appropriate method for small businesses with less inventory. If your business is small and self-employed like sole proprietorship or partnership, you should opt for the cash method, which is less sophisticated and simple to maintain. However, inventory-heavy companies should consider using the accrual accounting method. 

 

Suppose you own a public-traded company or any other big company. In that case, you should use the accrual accounting method because it smooths out earnings over time by managing your account receivables and payables. The bigger the business, the more it will need better accounting systems. Usually, as a business owner, your accountant will know the best accounting method to use. Still, it’s important to have this prior knowledge to understand why a certain method is chosen over the other. 

 

The Accrual Basis Of Accounting

Under the accrual basis, transactions are recognized when they occur, meaning expenses are recorded when incurred and revenue recorded when earned. The accrual principle states that you should recognize financial events by matching revenues regardless of when payments are made.

 

Pros And Cons Of Accrual Basis

The advantage of the accrual basis method is that it gives a more accurate picture of a company’s profitability since it shows the account payables and receivables. Companies using the accrual basis method may seem unprofitable when they are profitable. For example, a company can have sales that have been recorded, but payment has not been received yet. This approach means the company is doing well even though the books show otherwise. 

 

The other advantage of accrual basis is that it provides more useful information for business analysis through business ratios. The method makes it easy to prepare net profit margin, return on equity, accounts payable turnover, working capital, and total debt to assets ratio. With expense and revenue matched, the financial statements represent business health rather than what is shown by the checkbook.

 

The disadvantage of the accrual basis is that it might not track cash flows hence it’s difficult to account for cash shortage in the short term. Therefore, a company can look profitable in the long term but with a cash shortage in the short term. For instance, with our previous example, your business could show you are profitable from billed customer transactions but your bank account is still zero if the customer is yet to pay the invoice. Because of this, you need to pay close attention to your cash flows. 

 

The other disadvantage of the accrual method is that it is complex and therefore hard to implement because you have to account for items like unearned revenue and prepaid expenses. More skills, time, and resources are required to implement the accrual method than the cash basis. This is where using accounting software comes in handy. 

 

Example Of Cash And Accrual Basis Of Accounting

Suppose you own a business that sells cars. If a customer buys a car worth $20000 on a cash basis, that amount is not recorded in the books until you receive the cash payment or check. Under the accrual method, the $20000 is recorded in books as revenue immediately after making the sale, even if you will receive payment later.

 

The same concept applies to expenses. If you receive a water bill of $100 on a cash basis, the amount is not recorded until the bill is paid. However, under the accrual method, the $100 is recorded as an expense when you receive the bill.

 

Usage Of Cash And Accrual Basis: Which Method Is More Appropriate For Your Business?

Cash basis is the most appropriate method for small businesses with less inventory. If your business is small and self-employed like sole proprietorship or partnership, you should opt for the cash method, which is less sophisticated and simple to maintain. However, inventory-heavy companies should consider using the accrual accounting method. 

 

Suppose you own a public-traded company or any other big company. In that case, you should use the accrual accounting method because it smooths out earnings over time by managing your account receivables and payables. The bigger the business, the more it will need better accounting systems. Usually, as a business owner, your accountant will know the best accounting method to use. Still, it’s important to have this prior knowledge to understand why a certain method is chosen over the other. 

DISCLOSURE: THE INFORMATION PROVIDED TO MY READERS IS GENUINE AND PRECISE TO THE BEST OF MY KNOWLEDGE. THE LINKS PROVIDED IN THIS ARTICLE DO NOT BELONG TO ANY AFFILIATE PARTNERS AND I AM NOT PAID FOR THEM. THE ARTICLE OFFERS GENERAL INFORMATION AND SHOULD NOT BE USED AS A SUBSTITUTE FOR PROFESSIONAL ADVICE OR HELP THAT CATERS TO YOUR INDIVIDUAL BUSINESS FINANCIAL NEEDS AND GOALS. KINDLY SEEK HELP AND ADVICE FROM YOUR CERTIFIED ACCOUNTANT OR TAX PROFESSIONAL. ANY ACTION TAKEN BASED ON THIS INFORMATION IS AT YOUR OWN RESPONSIBILITY AND RISK. 

Mutugi Kithinji is a Finance graduate and professional with years of experience in Accounting & Finance. He's currently working towards finalizing his CPA, and is a contributor on EnidKathambi.

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