Cash Basis And Accrual Basis Of Accounting

The distinction between cash basis accounting and accrual basis accounting is in the order in which sectors of the economy are recorded in your books. Cash accounting only records revenue and expenses when money is exchanged, whereas accrual accounting records revenue when it is earned and expenses when they are billed. Before deciding on either accounting system for your company, it’s important to understand the key differences between cash and accrual accounting. Realising the differences between the two methods can help you better understand how they affect your business and choose the one that is right for you.

What is Cash Basis Accounting?

Small businesses that need to keep a record of their working capital use cash basis accounting. Because there is less to track, it is generally easier. Many small businesses are using this method for its simplicity. All revenue is recognised as it is received, and all expenses are recognised as the money is spent in cash basis accounting. This indicates that whenever individuals look at their bank balance, they’ll know exactly how much money they have, and their earnings won’t be taxed until the money is in the bank. Benefits of accounting, while easy and simple to maintain, the benefits of accounting do not always portray an accurate picture of a company’s true financial state.

Let us take an example of your financial status represented in the bank accounts may appear to be inappropriately good if your relationship with the corporation is profitable. Still, it has huge quantities of account payables that have yet to be paid. Investors may believe the company is about to turn a profit and continue to grow in this case, but it may actually be losing money due to unpaid accounts payable.

What is Accrual Basis Accounting?

According to accrual accounting, revenue is recognised when it is earned, and expenses are recognised when they are billed. This method is more common in larger companies, but it is usually more complicated and labour-intensive. If another entity or an individual owes your company’s money, and you’ve already sent an invoice, you’d record the amount due and owing by your client as income, even if the consumer hasn’t paid you yet. Larger companies are more likely to use this method. Accrual accounting gives a more clear financial picture of a company over time, and it’s especially useful for companies with a lot of inventory.

Despite the fact that the accrual method is more prominent among big enterprises, it does have some disadvantages. The accrual accounting method, unlike the cash basis method, does not vigorously track your cash flow. This can be extremely dangerous for business owners with financial distress in the short term. They may start spending finances they don’t get because they would seem to be very profitable in the long run, despite the fact that they don’t have any cash on their hands. To understand the real cash position of a business while using the accrual method, someone must keep track of incoming cash flow and outgoing expenses.

Key differences between Cash Basis and Accrual Basis Accounting

The main distinction between cash and the accrual methods is when revenue and expenses are received or paid and when they have been earned or incurred. Cash accounting is preferred by many businesses because the accounting information accurately reflects their own cash position, which in itself is especially crucial for small company owners. The ease of use also helps make bookkeeping easier and less expensive. A business does not have to pay interest on the income it hasn’t received if it uses cash-basis accounting.

The main disadvantage of cash basis is that earnings reports in any specified timeframe may appear distorted. Planning and forecasting can be complicated as a result of these distortions. Accrual accounting is the best model because it more accurately represents a company’s finances. With accrual accounting, businesses can easily keep track of credit transactions using an accounts receivable system, which displays each customer’s complete transaction history. An accounts payable system displays the transaction history between your company and a supplier. 

Another major difference between the two is that accrual basis accounting and cash basis accounting both can use a double-entry system. But, only cash basis accounting can use a single entry system. If we compare the nature of complexity, then cash basis accounting is simple, while accrual basis accounting is complex. Cash basis accounting is appropriate for small and micro businesses only. On the other hand, accrual basis accounting is appropriate for large businesses. 

Conclusion

The main distinction between the cash basis and the accrual basis accounting is the time lag between the occurrence and identification of revenue and expense. The former is typically used by small businesses, non-profit organisations, and government agencies, among others. In contrast, the latter is favoured by large corporations due to the speed with which transactions occur. The next distinction is that organisations that keep records on a cash basis enjoy tax benefits, whereas, in an accrual system, the entity must pay tax on income that has yet to be collected.