There are two methods used to record income and expenses in accounting, known as cash-based accounting and accrual accounting. The accounting method chosen will affect how transactions and business activities are recorded in the ledgers and will affect the final profit numbers. Small businesses generally like to use the cash basis of accounting, and large companies act on the accrual basis of accounting. The article provides a comprehensive explanation of each type of accounting and shows the similarities and differences between cash and accrual accounting.
This article will cover:
- Cash-Based Accounting
- Accrual Based Accounting
- Try to calculate the difference between cash basis and accrual basis.
- Accrual Based Accounting Versus Cash Accounting
- Advantages of Accrual Accounting
- Tax Practices of Accrual and Cash Accounting
- Which Method Should a small business Use?
- Which Accounting Method Should You Use?
The cash basis is an accounting method in which income is recognized and recorded when cash is deposited, and expenses are recognized and recorded when cash is withdrawn.
With this accounting treatment, income = income and expenditure = expense.
By the way, income refers to the deposit in cash or deposit in a certain transaction, and the opposite cash or deposit withdrawal is called expenditure. It’s a straightforward accounting method.
For example, a painter using cash-based accounting records income only after cash has been paid to him. The cash method is very simple and flexible. Cash-based accounting takes into account the cash movement or cash flows of the company. The disadvantage of cash-based accounting is that it does not record debit or credit accounts, making it difficult to manage. It does not show the full view of the firm’s activities, as cash-based accounting does not record debts and receivables; especially the firm’s long-term plans.
Accrual Based Accounting
Accrual accounting records income and expenses immediately when they occur. In other words, accrual accounting is not limited to cash and deposit expenditures and payments but must be recorded during the period when the need for expenses and income occurs.
Therefore, accrual accounting does not always hold income = income and expenditure = expense.
For example, a company using accounting on an accrual basis will record its income as soon as the work or services are provided and will not wait for the final invoice to be paid to be recorded as revenue. The same is true for expenses. Accounting on an accrual basis is approved by the Generally Accepted Accounting Principles (GAAP), used in the United States as the standard and principles used to produce accurate financial statements. The accrual method provides a clear overview of the income and expenses to be recognized in a period. It provides a full longer-term view of the firm’s activities, as it records debts and receivables.
Try to calculate the difference between cash basis and accrual basis.
As mentioned earlier, the clear difference between cash basis and accrual basis is the timing of accounting for expenses and income. Let’s calculate what kind of difference it makes by taking an actual transaction as an example.
- March … Purchased $100,00 products (payment is the following month)
- April … Payment of purchase price of $100,00 for products purchased in March, sale of products purchased in March for $15000 (the price will be collected in May of the following year)
It’s reasonably simplified content, but the above content is a transaction with accounts receivable and accounts payable. Let’s compare the profit and loss at the end of April at this time.
- Cash basis … $10000 deficit (only cash expenditure of $10000 for purchase in April)
- Accrual basis: Surplus of $5000 (Sales in April $15000 -Purchasing in March $10000)
On a cash basis, only cash expenditures are booked. The only cash movement in the March and April transactions was the payment of the purchase price in March. On the other hand, on the accrual basis, purchases in March and sales in April are recorded because the book is recorded when the transaction occurs. Because of these differences, accrual accounting is used to get an accurate picture of the financial situation when cash transactions are not mainstream.
Accrual Based Accounting Versus Cash Accounting
The main contrast between the two types of accounting is when income and expenses are recorded. In cash-based accounting, the amount is recorded when cash is actually received and expenses when they are actually paid (regardless of when they are invoiced). To clarify the difference between the two methods, we take the example where a business sells a product, and the customer pays on credit:
- Income is recorded immediately using accrual accounting
- No income is recorded until the loan is paid using cash-based accounting.
Similarly, if a company incurs an expense and pays on a loan, in accrual accounting, the expense is recognized immediately rather than deferred until the loan is recognized in cash.
The advantage of cash-based accounting is simple – managing cash flow in real-time is more manageable, with just checking the bank balance rather than reviewing accounts receivable and accounts payable. Given that most businesses fail due to cash flow mismanagement, companies using accrual accounting still need to execute cash flow analysis.
Advantages of Accrual Accounting
However, cash-based accounting gives an instant picture of the business cash flow. In contrast, accrual-based accounting shows the business’s long-term status more accurately – income and expenses are immediately recorded. The company is allowed to analyze trends and manage finances more accurately.
Accruing accounting makes it easy to match income with expenses. For example, if you, as a contractor, paid $6000 for building materials for a project in September, you completed the work in the same month, but could not receive your payment using cash accounting until the next November will expire in September, but the next one covers November’s big profit for the period. With accrual accounting, you would record the business’s income in September of the month you paid for the materials.
Tax Practices of Accrual and Cash Accounting
Whether your business uses accrual or cash accounting can significantly affect taxation. For example, if your financial year is at the end of June and your business invoices a customer for $ 50,000 in May this year but fails to receive payment by May of the following year, $ 50,000 in the current tax year under the accrual method will be included in the following year using the cash method.
Which Method Should a small business Use?
Many sole proprietorship and small businesses use accounting on a cash basis; however, accrual accounting is the accounting method required by law for most companies and professionals in the United States and Canada.
Which Accounting Method Should You Use?
Suppose your business carries inventory and sells goods. In that case, you need to use the accrual method as with any company that lends customers to customers, as cash accounting cannot track customers’ money owed to an account.
Most anonymous businesses use the accrual method. Public companies registered on the stock exchange are required to follow Generally Accepted Accounting Principles (GAAP), which requires accrual-based accounting because investors want the most accurate picture possible of a company’s financial condition. If in doubt, consult your accountant about which method you should use.