Before you choose either accounting method for your business, you should know the major factors that differentiate cash accounting from accrual accounting. Knowing the differences between the two methods helps you understand their effects on your business and zero in on the one that will work best for you.
1. Revenue and expense recognition in cash and accrual methods
The first difference between cash accounting and accrual accounting is the time when transactions are recorded (when revenue and expenses are recognized).
In cash accounting, the exchange of cash decides when revenue and expenses are recognized. Here, a business records revenue when cash is received, and expenses when cash is paid.
In the accrual approach, cash flow has no part to play in revenue and expense recognition. Here, revenue is recognized when it is earned. Expenses are recognized according to the matching principle, which states that all expenses should be recorded together with the corresponding revenues earned in the same accounting period.
For example, you incur an expense in the form of commission to your salesperson. The salesperson earns a commission of $1,000 for a sale they executed in January, and the commission is paid in March. According to the matching principle, you must record both the sale and the expense in the same period, which is January.
2. Single-entry and double-entry accounting
The next difference is the type of accounting system. There are two widely-used accounting systems: single-entry accounting and double-entry accounting.
The foundation of cash accounting is the single-entry system, in which you record transactions as single entries in a cash book or journal. The cash accounting approach uses this system to record transactions, which are either cash coming in as payments or cash going out as expenses.
In accrual accounting, you use a double-entry system in which every transaction is recorded under a minimum of two accounts. Each transaction results in a credit in one account and an equal debit in another. Large companies using accrual accounting prefer the double-entry system, as it makes it easier to record credits and debits for various accounts like assets, liabilities, income, expenses, and equity.
3. Accounts receivable and accounts payable
Accrual accounting has two unique components: accounts receivable and accounts payable. They are significant for any business that buys and sells on credit.
Accounts receivable is the sum of money owed to your company as a result of credit transactions in which revenue is earned before cash is received. It is an asset account, because it signifies an impending payment coming into your company.
Accounts payable is the total money that you owe to your vendors when you have bought supplies from them on credit and haven’t paid them yet. It is a liability account, because it indicates a payment that you have to make to a seller.
Cash accounting does not record accounts receivable and accounts payable, because transactions are recorded when money is exchanged. There is usually no credit or debit involved, so there isn’t any revenue or expense to be recorded later.
One of the most significant differences between cash and accrual accounting is their effect on taxes. Because revenue and expense recognition varies depending on whether you follow the cash or accrual method, this ultimately affects when you have to pay your taxes. To understand this better, let’s consider the following scenario for both methods.
You invoiced your client for $2,000 on December 1, 2018. Your client paid the invoice amount on January 31, 2019.
Under cash accounting:
You pay taxes for this transaction as a part of your 2019 income. This is because you record the sale in 2019, when cash was received from the customer.
Under accrual accounting:
You pay taxes for the transaction as a part of your 2018 income. This is because you record the sale in 2018, when you sold the goods and invoiced the customer.
It’s vital for every organization to measure its performance and determine its financial position. Financial statement reports help you with this. The three most useful financial reports for any organization are the cash flow statement, the balance sheet, and the income statement or profit and loss statement. These reports work differently in each accounting method.
The cash flow statement contains records of cash inflow and outflow. In the cash accounting method, the company records transactions when cash comes in or goes out, so the cash flow statement gives an accurate picture of how much money there is in your company at any given time. In the accrual method, transactions are recorded without regard to cash flow. This means the cash flow statement does not really provide a clear understanding of how much money you have in your company.
The balance sheet provides information about your company’s assets and liabilities at a given point in time. It includes details of what you own (your assets), what you owe (liabilities) and what is invested in your business (equity). In the cash basis of accounting, since companies don’t record accounts receivable and payable, the balance sheet does not reflect assets or liabilities. In the accrual method, the balance sheet provides every detail regarding assets, liabilities, and equity. The accounting equation (Assets = Liabilities + Equity) helps you ensure that your company’s records are in balance.
The income statement provides insights on the company’s income, expenses, and profit or loss over a period of time. In cash accounting, there are chances that the company reports an amount on the income statement that is not the actual profit gained, or loss incurred during the transaction. This is because the company might not receive the full amount or record the full expense for said transaction in the period for which the income statement is generated. This provides an inaccurate picture of profitability. In the accrual method, transactions are recorded with the full profits gained or losses incurred in the given period for which the income statement is generated. The records from the income statement help you know if your company can gain profit by increasing revenue or decreasing your costs. It gives a better view of profitability.
Pick what’s best for you
Choosing the appropriate method of accounting for your business is a lot easier once you know how the choice affects different areas of your accounting. Implementing the cash method for your business makes accounting and recording your cash flow simple, so if you have a very small business and you record everything in terms of cash flow, the cash accounting system is the better choice to make. If you’re a large business buying and selling on credit, and you record accounts receivable and accounts payable, the accrual method is probably the wiser choice.