Cash Accounting vs. Accrual Accounting – Key Basis of Accounting Differences
In accrual accounting, expenses and revenue are documented as soon as they happen. In cash basis accounting, nothing is documented until cash is exchanged.
The difference between cash and accrual accounting lies in the timing. When are sales and purchases being recorded in a bank account?
Accrual Accounting Method
In the accrual method of accounting, revenue is accounted for when it is earned. In terms of bookkeeping, this means everything is recorded before any money changes hands. It is accepted on an accrual basis.
Unlike the cash method, accrual basis accounting assumes the customer is good for the charge and the money will be paid in the future. Products and services are delivered with the expectation of payment. Despite no cash being paid, the transaction and expense are documented in that accounting period.
Cash Basis Accounting
In a cash basis accounting system, revenue is reported on the income statement only at the time cash is received. Expenses are only documented when cash is paid out and not on gross receipts. This type of accounting is generally used by small business owners and bookkeepers for personal finances.
The Main Differences in Cash vs Accrual Accounting
When it comes to the cash method of accounting, the key advantage is simplicity. It’s much easier to track cash flow. That’s why it’s a favorite for smaller companies where business income is more manageable.
Generally Accepted Accounting Principles
Although it can lead to what looks like a healthy balance sheet, cash-based accounting is not part of the generally accepted accounting principles (GAAP). It can deeply skew your financial statements.
The accrual method is part of GAAP and is the popular choice when it comes to business accounting. It’s the most commonly used method by publicly traded companies and leads to more accurate financial reporting.
The accrual method smooths out earnings over time. It accounts for all expenses and revenues as they are generated rather than being recorded intermittently under the cash-basis method.
For example, under cash-based accounting, a retailer will look extremely profitable in Q4 as people buy for the holiday season. On the flip side, the following Q1 (and tax year) will look unprofitable as consumer spending declines after the holiday rush. The end of the year is what truly bolsters annual sales.
Although the key to a cash method is the ease of use (it only accounts for cash paid or received), this strategy might overstate the financial health of a company. Especially if they are cash-rich but have a large volume of accounts payable.
If AP far exceeds the cash on the books and your current revenue stream, this could mean trouble. At any given time, an investor might believe a company is making a profit when they are actually hemorrhaging money.
The accrual method includes the data from accounts payable and accounts receivable. As a result, it forms a more accurate picture of the long-term profitability of a business. The reason for this is because the accrual method accounts for all revenues when they are earned, and all expenses when they are incurred.
For example, a company might have ongoing sales in the current quarter that would only be recorded under the accrual method. If you were using a cash system, an investor might not conclude the business is profitable during this time period.
That’s because revenue isn’t expected until the following quarter. The company is doing well but they have nothing to show for it when using the cash-based method. Only the accrual method will demonstrate profit to investors.
The accrual method doesn’t track cash flow. As a result, it might not account for a company that has a serious cash shortage in the short term, even if they look good in the long run.
Accrual accounting is also more difficult to track. Especially when you are dealing with prepaid expenses and unearned revenue. However, CPAs choose this method to better determine taxable income for your tax returns.
Both types of accounting have advantages and disadvantages, and each only show a part of the financial health of a business. When making critical investment decisions, it’s important to fully understand how both strategies work.
Accrual Accounting vs. Cash Basis Accounting Example
Let’s say you own a company that sells medical equipment. If you sell $4,000 worth of hardware, under the cash method, that amount is not accounted for until the customer comes with cash in hand or a payment is made.
Under the accrual method, the $4,000 of revenue is immediately recorded, even if the money is received weeks later.
The same applies to expenses. If you receive a water bill for $200, under the cash method, nothing is added to the books until the bill is paid. Under the accrual method, the expense is recorded the day the bill is received, not the day it is paid.
Which is the Best Method?
This depends on several factors. Cash basis accounting is easier but accrual accounting is more accurate. That’s because it involves all aspects of your finance department, including accounts payable and accounts receivable. The accrual method is the most common but that doesn’t mean it’s the best fit for your business.
A Universal View
For accounting purposes, the most successful strategy, regardless of the industry, is the accrual method. Cash-based accounting can truly distort the bigger picture and incorrectly reflect income. This has a serious effect on who invests in your business. For startups, this is a crucial move.
In cash-based accounting, income is only recognized when money is received and an expense when money is paid. Accrual recognizes income when goods are shipped or services rendered. An expense is recognized when a business is obligated to pay it (i.e. receives an invoice).
Accuracy and Transparency
If in a given period you collect very little receivables, but pay a lot of bills, under cash accounting, you have expense without any income. In this case, it will appear as if the business has lost money.
On the other hand, if you don’t pay any bills but collect a lot of receivables, you have a lot of income on record. This is a major distortion of what has actually occurred. In accrual-based accounting, it doesn’t matter how many bills you’ve collected or paid.
Income (whether it is received or not) is always matched to an expense (whether it is paid or not). This results in a proper match of revenue. The expense is generated to produce the inflow of cash.
In business, it is possible to use one method for accounting and the other for tax purposes. But, as everyone knows, tax issues can get complicated. For best results, always use the accrual method for serious accounting and cash-based for smaller operations.