The key difference between cash vs accrual accounting lies in the timing of the expenses and revenue recognition. The cash method offers an immediate recognition of the expenses and the revenues, while the accrual accounting method focuses on the anticipated expenses and revenue.
In this article, we shall explore the differences and learn how each accounting method affects a company’s accounting decisions and why the accrual basis of accounting is generally preferred over the cash basis.
So, without any further delay, let us begin.
- The accrual method of accounting records the revenues and the expenses when a transaction takes place, but that happens before dispensing or receiving the fund.
- Cash-based accounting records the revenues and expenses when the fund related to the transactions is actually dispensed or received.
- The accrual accounting method offers a more defined and accurate view of the health of a company by including the accounts receivable and accounts payable.
- The accrual method is the more preferable method by the bigger companies, particularly the ones that conduct public trade. This is because it helps in smoothing out the earnings over time.
- Smaller businesses or sole proprietors are the main users of the cash basis method.
What Is Accrual Accounting?
Under this process of accounting, the revenue accounts with the earnings. Unlike the cash accounting method, the accrual method keeps track of the revenue when a service or product reaches a customer with the expectation that they will pay money in the future.
In simple terms, accrual accounting accounts for the money before the business actually receives it. Likewise, the expenses for the goods or services are recorded before any of the cash is paid out for them.
What Is Cash Basis Accounting?
While following this method, the revenue reports on the income statement only when the cash comes through. Similarly, the business records the expenses when the cash moves out. The cash method is generally used by smaller businesses or for personal finances.
Cash Vs Accrual Accounting: Key Differences
The theoretical definitions of each of the accounting techniques are fairly simple. Let us now focus on the key differences between the cash vs accrual accounting methods.
The accrual accounting methods record the accounts payables and receivables. As a result, it paints a more accurate picture of a company’s profitability, mainly in the long term.
For instance, a company that has sales in the current quarter will not record it under the cash accounting method. They also expect the related revenue in the following quarter. An investor may think that a company is not capable of generating profit when, in reality, the company is really doing well.
The accrual method does not keep track of the cash flow. A company might seem profitable in the long term, but it actually has a challenging, significant shortage of cash in the short term.
Another disadvantage of accrual accounting is that it may be more complicated as it’s necessary to account for items like unearned revenues or prepaid expenses. It may also require an addition of staff.
Cash Basis Method
The primary advantage of the cash method is its simplicity. It just accounts for the received or paid cash. Tracking the cash flow of a company is also far easier.
It is beneficial to sole proprietorships and other small businesses as, in most likelihood, it will not require any extra staff to use.
However, the cash basis method may overstate the health of a company that is rich in cash. That is because it does not record the accounts payable, which might exceed the cash on the books and the current revenue stream of the company.
As a result, an investor may conclude that a company is making a profit when, in reality, the company is facing financial difficulties.
The rules of GAAP do not accept the cash basis method of accounting.
Cash Vs Accrual Accounts: Special Considerations
The accrual method is a lot more commonly used method, mainly due to the public-traded businesses. The key reason for the popularity of the accrual method is that it smooths out the earnings over time. It also accounts for all the expenses and revenues they generate. The cash basis method records these only when there is an exchange of cash and presents fluctuating views of profitability.
For instance, under the cash basis method, the retailers appear profitable in Q4 as consumers purchase for the holiday season. However, they would look unprofitable in the Q1 of next year as consumer spending reduces after the holiday rush.
Each of the methods has its own advantages and disadvantages. Each of them provides different pictures of a company’s financial health. For investors, it is important to understand the impact of both methods when they are making any investment decisions.
Cash Vs Accrual Accounting Examples
Let us imagine you work for Tata Motors which sells machinery. If you are selling $5,000 worth of machinery under the cash method, you will not record the amount in the books until you have the money from the customers in hand or receive a check.
However, in the accrual method, you’ll record the $5,000 as revenue for the date of the sale. Though, you might receive the amount days, weeks, or perhaps months later.
Cash vs accrual accounting are two of the most popular accounting methods in any business. They have their own benefits and drawbacks. Every businessman should be aware of them before choosing to follow either of the methods.
While the accrual method records the amounts before the payment is made, the cash-based method will do so once you have the cash in hand.
These two types of accounting have distinctive purposes and are used accordingly by different types of companies. Whichever method you choose, you must have an accurate understanding of your business type and the accounting styles, too.