As the adage goes, “Accounting is the language of business.” If money is the entrepreneur’s fuel to run the business, accounting is the heart of financial matters. It is crucial to have a good understanding of which accounting method works for the kind of business you have together with the nature of its financial facets. Let us get into business and start counting the differences between cash accounting and accrual accounting.
Put, cash basis accounting is an account for transactions when cash changes hands. One, when the cash is received from the customer, revenues are accounted; two, when the cash is paid out to deliver the service or finish the product, expenses are considered for.
No account receivable
Cash basis accounting does not keep records of receivables. Meaning, payments that you receive at a later time than your actual service are nowhere to be found on this accounting method.
Cash Basis accounting is an account of actual transactions. When you pay, account right away. When you receive, account right away.
Since cash basis accounting has a simple structure of accounting procedure, it doesn’t take a genius, or in this case, a certified public accountant (CPA) to man the accounting and record-keeping of financial matters. It is effortless to maintain, and it will help you save expenditures for personnel.
In layman’s term, the accrual basis of accounting means income is recognized when they are receivable or to be received on a given time rather than when they are received on hand, and accountabilities are recognized when they are payable rather than when they are paid out.
Records when earned/account receivable
Under the accrual basis, income is recognized when made regardless of when received (earlier or later than the date of a business transaction) and expenses are recognized when incurred regardless of when paid.
Accounts during the occurrence
When practicing accrual accounting, the effects of transactions are recognized when they occur and not as cash or payment is received or paid, and are systematically recorded in the statement of account or financial statements of the periods to which they relate or occurred.
Displays the “bigger picture.”
Accrual accounting has the upper hand when it comes to displaying a bigger picture or a more accurate reflection of the profitability of a business. This is primarily because of its accrual nature, recording all revenues when they are earned and all expenses when they are incurred.
Salient Features and Loopholes
Cash accounting is best when tracking the actual amount of cash the company has at any given time. Your business’ cash flow is your reliable reference as your cash on hand and/or your bank account balance reflect your finances and realize how much you are earning or losing and maximize your resources in the best way possible.
The loophole in the cash method is that your income statement, revenues, and expenses do not give you a clear picture of your financial activity for a specified period. Cash basis will not help you foresee your business’ financial stability in the long-term.
Another thing to consider is that this accounting method is not accepted under the Generally Accepted Accounting Principles as one of the ruling standards in accounting.
Accrual accounting is best when you want to keep track of your financial activity for specific periods to salvage your revenue and expenses, check your accounts payable, accounts receivable, income and expenses and foresee financial setbacks and opportunities in the future.
Also, accrual accounting can cater to companies that have complex financial structures and activities that can’t be done under the basic principles of cash basis accounting.
Accrual basis seems to be shorthanded though in providing a blueprint of your cash flow. Your small business’ income statement may seem to flaunt whopping figures while your bank accounts and unstipulated expenditures may tell you otherwise.
Which one counts for your business?
Choosing between cash basis and accrual basis is a critical decision for a greenhorn entrepreneur who knows little knowledge about these methods of accounting before even thinking of using or integrating an accounting software to their system. Accounting per se can be controversial in the sense that it may or may not truly reflect a company’s financial performance because some accounting rules and methods are vague and may be subject to personal interpretation of an accountant.
So how do you choose between cash basis and accrual basis as the more appropriate accounting method for your business?
Let us count in and out by scrutinizing these particular effects of cash basis and accrual accounting to the cash flow to know what’s best for your business:
For cash basis accounting, your business income is not taxed until the cash is received. Pretty simple: no cash, no tax.
For accrual accounting, your income taxes are based on what you have earned for a certain period regardless if you have received the complete payment from your services over that period or not.
However, cash-basis accounting provides more viable financial transactions of your business though it will be limited to cash received and paid out only. Nevertheless, both cash basis and accrual accounting can provide comprehensive income statements and balance sheets with ample careful attention to detail.
Tale of the Tape: Cash basis Vs. Accrual Accounting
Let us summarize the qualities of cash basis accounting method in comparison to the accrual approach of accounting
Cash Basis Accrual
simple format complex format
does not follow GAAP follows GAAP
actual cash received and paid out cash, receivables, and payables
records immediately record as it occurs
best for small businesses best for bigger businesses
reflects cash flow reflects accrued revenue and expenses
Thus, the cash basis approach does not account for receivables, payables, accrued income and expenses, and deferred income and expense.
Meanwhile, the essence of accrual accounting is to recognize receivables, payables, accrued income and expense, and deferred income and prepaid expenses.
So, what’s the real score?
Upon realizing the apparent nuances, effects, nature, and specific characteristics of the two accounting methods, you now have a clearer picture in mind as to which accounting method will work best for your incipient or assumed business.
In case you cannot pinpoint the primary essence of differentiating between cash basis and accrual accounting, let us set it in stone once and for all. The most glaring difference between cash basis accounting and accrual accounting is plain and straightforward – timing. Yes, timing is that thin line that sets accrual accounting and cash basis apart from each other, the timing of when (pay and receive) transactions are recognized.
Accrual and cash basis methods of accounting have their fair share of strengths and weaknesses, and both also diversely reflect the financial status of a business. Having a good grasp of these two accounting methods will help you land to a sound business decision that will determine the make or break of your financial account, the heart of your business.
After a brush through to the two primary accounting methods, you now have to seal the deal!