Some businesses may choose either cash or accrual based accounting to do their bookkeeping, generate their financial statements and file their tax returns. However, it may be beneficial for business owners to implement a variance of their financial recording between accrual and cash based accounting practices.
In this article, we are going to discuss cash based accounting and accrual accounting. First of all, let’s start with the meaning of these two terms.
Definition of Cash Based Accounting
Cash accounting involves recording income when it is received and processing payment transactions when it is paid. Unlike the accrual based accounting method, aligning cash receipts (sales) with their corresponding cash payments (cost of goods sold) is more difficult. However, the cash accounting method allows management to monitor their previous monthly cash flow practices from a bird’s eye view.
The cash-based accounting identifies and accepts revenues only when the cash is received, and paid expenses. Accounts Receivable and Accounts Payable are not recognized in this factor of accounting.
Considering its Simplicity and accountability, many small businesses consider opting for cash-based accounting. It’s very easy to track the financial transactions if any and hence there is no necessity for Accounts receivable and accounts payable to come into picture.
The benefits of Cash Based Accounting:
- Business owners can determine if they were able to afford their day to day operational overhead based on the timing cash receipts were recorded versus the demand of their monthly overhead.
- Based on cash receipts, management can pin point trends in cash flow to schedule cash payments in the future.
- Management could restructure their business plan based on their ability to manage their cash flow from month to month.
The cash method actually benefits you in tracking how much your business withdraws cash at any given time. And, since there will be no record of transactions until the cash payment or delivery, You will not be able to tax your business profit and income.
Definition of Accrual Based Accounting
Accrual accounting is the process of recording transactions as they occur, regardless if cash is received or paid. This method of accounting is used more often than cash based accounting. Business owners are able to review their accounting records to effectively determine management’s ability to operate a business.
Accrual accounting records the revenues and expenses when they are earned, nevertheless of when the money is actually received or paid. Say, for example, only when a project is complete, you go to record the revenue comparatively when you get paid. Hence, this accrual method is more widely used than the cash method.
A positive aspect of the accrual basis is that it gives a more practical idea of income and expenses during the accounting period, and it consequently provides a long-term ideology of the business that cash accounting never provides.
The benefits of Accrual Based Accounting:
1. Sales are recorded as they occur; therefore, it will be easy to determine if they have met their sales quotas. As well they can determine how many days aged their Accounts Receivable are.
2. Purchases can either be recorded when the purchase order is generated or when the invoice is issued from the supplier:
- By recording the purchase transactions on the date of the purchase orders, business owners can align their sales with the corresponding cost of goods sold (beneficial for larger sales and project accounting). Therefore, periodic financial statements can accurately reflect the gross margin of total sales.
- By recording the purchase transactions on the invoice date from the supplier, business owner’s can determine on their own records the number of days aged for each Accounts Payable.
3. Corporate taxes will be calculated on the actual transactions as they occur. Depending on the tax strategy of the business this may or may not be a benefit.
The limitation of accrual accounting is that it doesn’t provide any acknowledgment about cash flow. A mirage can appear straight in front of you. As you find your business running much successfully but in reality, it has bare bank accounts. Caution must be kept near you while working in Accrual accounting. If there is negligence in careful monitoring of cash flow then it can lead to severe ravaging results.
Cash Based vs Accrual Based Accounting: Which one to choose?
For small business owners, it is more beneficial to record their business transactions via the accrual accounting method; however, it is also important for business owners to monitor their operations on the cash accounting method. A suggestion would be to adopt the accrual accounting method for bookkeeping and maintain a check log (cash ledger) that reconciles to the bank balance as a live document.
Several accounting software packages have modules for cash flow management; however, it may require additional analysis. Therefore, using a cash ledger spreadsheet may be beneficial for business owners who experience high volatility in their cash flow. A cash ledger spreadsheet allows small business owners to plan their purchases more effectively with greater flexibility than utilizing their accounting software.
Cash ledger spreadsheets allow users to enter data to plan their cash flow with minimal editing. As well, business owners can strategize multiple scenarios with ease while their financial records (accrual accounting method) remain uncompromised. Business owners should know with confidence their ability to manage their cash flow as well their ability to operate their business. Therefore, consider accrual accounting for your bookkeeping while monitoring your cash flow through a cash ledger spreadsheet; the extra work will pay itself over and over again.
Cash Based And Accrual Based Accounting Examples
A real-life example is quoted below for revenue and expense recognition:
- Revenue recognition: An organization is selling $900 of garden equipment to their customer in November month, which will pay the invoice in December. From the perspective of the cash end, the seller recognizes the sale in December, when the actual cash is received. From the accrual perspective, the seller identifies the sale in November itself, when it distributes the invoice.
- Expense recognition: A company buys $1300 of office furniture in February, which it will pay for in March. From the cash perspective, the customer identifies the purchase in March, when it actually pays for the invoice. From the accrual perspective, the customer recognizes the purchase in February, when it receives the provider’s invoice.
Differences Between Cash And Accrual Based Accounting
The below comparison chart shows the differences between cash basis and accrual basis clearly,
|CASH BASED ACCOUNTING||ACCRUAL BASED ACCOUNTING|
|Revenue is identified when as soon cash is received||Accrual accounting recognizes revenue only during the accounting period completion.|
|Cost price(Expenses) are recognized when actual money in hand is spent||Expenses are recognized when an invoice is received|
|Need not pay tax for the money that has not reached your hands.||The Tax must be paid for the debt that you’re liable to.|
|Usually, it is owned by small businesses.||Accrual accounting is used by large ventures who own turnover in millions.|
Any type of accounting (including cash basis and accrual basis) uses the below 3 financial statements as records. So there is nothing wrong with getting familiar with these statements. These statements primarily concentrate on financial transactions and track revenue.
- Balance sheets: This sheet shows if your assets(properties) equal your debts.
- Income statements: To calculate your net income, Income statements normally list your profits and losses.
- Cash flow statements: This clearly records how much cash is flowing in and out of your business. It also records the profit and loss of the business.
Internal Revenue Service(A Federal Agency) claims that Cash-based Accounting is the easiest accounting method for recording and tracking any financial transactions because there is no need for any intrusion into complex accounting transactions namely accrual and deferrals.
IRS also suggests that the Cash-based method is the only practical method available if a company settles within $5 million in sales per year.
IRS is the one who brought light to the accounting world that Cash-based accounting methods should be used by small businesses because of their flexibility.
Let us see further what the IRS suggests about Accrual Accounting.
IRS recommends Accrual accounting to come into practice only if the company’s sales exceed over $5 million. And truly, larger companies are flexible to use the accrual basis method to record their financial transactions.
Magically, Through accrual accounting, the business financial results have a higher probability to match revenues and expenses in the same accounting period, which makes it easier to calculate the exact profitability of the business.
The IRS standard statements of cash basis and accrual basis of accounting have led to an easier understanding of concepts and the practical way to use them among financial accountants.
Their statements are widely accepted by many economists too.
Merits Of Cash Based Accounting Over Accrual Based Accounting
One advantage of the Cash basis method is it is more immediate(faster) in recognizing revenue and expenses, whereas the accrual-based method of accounting concentrates on the predicted and foreseen revenue and expenses.
Cash-based accounting is primarily used to track the cash flow through the company. Accrual-based accounting always includes accounts receivables and payables for the long-term profitability of a company.
Again, bringing the important idea in both one more time. The difference between the cash basis and accrual basis of accounting is the recorded timing of the revenue and expenses.