There are two methods in accounting: cash basis and accrual. Cash basis accounting is more straightforward, while accrual accounting is more complex but provides a more accurate picture of your company’s financial health. This post will explain the two types of accounting methods to decide which way best suits your business.
What is Cash Basis Accounting?
Cash basis accounting is a more straightforward accounting method for your business transactions. Cash basis accounting is a financial reporting method that records revenue and business expenses when cash exchanges hands. This system contrasts with accrual accounting, which records transactions when they occur, whether money has changed hands.
Cash basis accounting makes it easy to track how much money you have on hand. However, cash basis accounting does not provide a complete picture of your company’s financial health, as it does not account for accrued expenses or income.
Example of Cash Accounting
An example of a cash basis accounting transaction would be when a business receives cash from a customer for a product (e.g., a pair of jeans, headphones, a candy box). The company records this revenue as soon as they receive the cash.
Conversely, an example of an accrual accounting transaction would be when a business records revenue on its books for products that have been shipped to customers but not paid yet. Income is recognized at the point of sale under accrual accounting principles even if the business has not received payment.
Advantages of Cash Accounting
The benefits of using cash basis accounting include:
- Simplicity–you can understand how much money your business has and where it came from;
- Timeliness–you don’t have to wait until the end of the month to see how your business is doing;
- Accuracy–since only actual cash transactions are recorded, there’s less opportunity for error.
On the downside, because cash basis accounting doesn’t consider outstanding invoices or bills so you can’t use it if your business relies on credit to make sales.
Disadvantages of Cash Accounting
One of the major disadvantages of cash basis accounting is that this method cannot account for obligations that will occur in the future.
For example, if a business pays its rent for the upcoming month in advance, they would not reflect this payment in its books under cash basis accounting. In contrast, accrual accounting considers all outstanding liabilities and revenue streams, regardless of when they occur.
What is Accrual Basis Accounting?
Accrual accounting is a popular way for companies to report their financial performance. The method tracks revenue and expenses regardless of when cash changes hands, which can help compare one company’s growth over time with another’s or whether they were profitable at any point during this fiscal year.
However, accrual accounting can be more complex than cash basis accounting, so it may not suit smaller businesses with less complicated finances.
Example of Accrual Accounting?
An example would be a business that bills its customers for plumbing services. A plumber fixed a leak last week and is now sending the bill due in 14 days. However, the payment is not recorded in the company’s books until the customer pays the bill. Again, this is because the cash has not changed hands yet.
Accrual accounting can provide a more accurate picture of a company’s financial health since it records transactions as they happen, rather than when cash changes hands. As a result, accrual accounting makes it less susceptible to timing irregularities.
Advantages of Accrual Accounting
The benefits of using accrual accounting:
- It gives an accurate view of a company’s financial health, considering receivables (money owed to the company) and payables (money the company owes).
- It can help manage taxes, as tax liabilities can be accrued and paid later.
- It’s suitable for businesses with long payment cycles as it allows them to record revenue and expenses before the actual cash transaction.
- It can help manage cash flow, allowing firms to expect payments and costs better.
Disadvantages of Accrual Accounting
Accrual basis accounting is the preferred method for many businesses. However, there are some disadvantages to using this system:
- It can be more complex than cash basis accounting, making it difficult for small business owners to understand and use.
- Accrual accounting can be less flexible than cash accounting, since transactions match revenue with expenses. For example, a company that sells products on credit will have to record income from those sales even if the customer has not yet paid them.
Which Method is Best For You?
Both have benefits and drawbacks, so it’s essential to understand the difference before deciding.
Cash basis accounting is more straightforward than accrual accounting. Transactions are recorded when cash changes hands, which means you don’t have to worry about recording bills that haven’t been paid yet. This can be helpful for businesses that are just starting because it’s easier to track what money is coming in and going out.
Accrual accounting is more complex, but it gives a more accurate picture of your business’s financial health. Invoices that have been incurred but not paid will be recorded in the books under accrued expenses. This can help you keep tabs on how much money you’re spending and make better decisions about your budget.
So which is right for you? It depends on your business and how much accuracy you need in your financial reports. Cash basis accounting might be a good place to start if you create. However, if you want more precision in your business finances, accrual accounting is the way to go.
