The Difference Between Accrual And Cash Accounting: Which Is Best For You?

The Difference Between Accrual And Cash Accounting: Which Is Best For You?

Accrual and cash accounting are the two most common methods of recording business transactions. Both systems provide distinct advantages and disadvantages that can affect how a business does its bookkeeping. Knowing the differences between accrual and cash accounting can help business owners define which might be a better fit for their company. 

This article will explore the features of each type of accounting, their advantages and disadvantages, and how to determine which one is right for a business.

What is Accrual Accounting?

Accrual accounting is a method that implies recording transactions for incurred liabilities or earned assets, regardless of whether the cash was paid. 

Usually, businesses that sell products or services on credit use the accrual method to do their books. This way, they record sales or expenses as soon as they occur rather than when payments were made or received. 

Accrual accounting is considered a broader and more encompassing method than cash accounting. Its goal is to match revenues and expenses with the correct periods, regardless of whether those revenues or expenses have been collected in cash or are still owed. As a result, it provides a more accurate picture of a business’s financial health than cash accounting. It can also make it easier to determine whether a business’s revenues are adequate to cover its expenses.

Advantages of Accrual Accounting

Here are the advantages of the accrual accounting method:

A more accurate picture of a business’s financial health. Accrual accounting helps accurately track a business’s revenues and expenses. It records sales when customers have received and used the product and the cost of goods and services when they have been received and used.

Tracking actual profit and loss. Accrual accounting helps business owners track their actual profits and loss. This method enables business owners to match revenue and expenses to the correct periods helping them predict future financial performance more accurately by recognizing fluctuations in sales and revenue.

Easier cash flow forecasting. Accrual accounting can help business owners forecast their cash flow more accurately. This forecasting can help the company plan for future expenses and determine whether a project will produce enough revenue to cover its costs.

Accounting for revenue when customers have paid in advance. Accrual accounting can help track revenue when customers have paid in advance, which makes it helpful for service businesses, such as plumbers, electricians, and auto mechanics, who are usually paid for their work in advance.

Disadvantages of Accrual Accounting

On the other side, businesses might want to consider potential drawbacks before deciding whether this approach will work best for their needs. These include increased complexity in record-keeping requirements, difficulties related to budgeting and taxes calculations, etc. Let’s look at them in more detail.

More complex record keeping. Accrual accounting requires more complex record keeping than other methods, such as cash-based or modified accrual, because you need to track all assets over time rather than just at one point. Moreover, you need to handle multiple accounts, such as unearned revenue, accounts payable, receivables, and liabilities. At this point, using accounting software might help overcome these challenges.

Difficult to track cash flow. The accrual method doesn’t show a correct picture of a business’s cash flow. You may have thousands of dollars in revenue reflected in the income statement while not having cash on hand until your customers fulfill the invoices. So you might want to generate cash flow statements regularly to stay in the current of your cash flow.

Potentially hard for budgeting. Another disadvantage associated with accrual accounting is that it can make budgeting difficult due to its use of estimates for future revenue and expenditures, which may not accurately reflect actual results once they occur. Without proper planning and monitoring, it can result in unexpected losses or gains depending on the accuracy of the initial estimates. 

More difficult tax calculations. Finally, using accruals makes tax calculations more complicated since taxes are based on actual amounts received rather than estimated ones recorded under an accrued basis system like GAAP (Generally Accepted Accounting Principles).

What is Cash Accounting?

Cash accounting implies recording transactions (revenue or expenses) when cash has been paid or received. The method is easier to perform compared to accrual accounting. However, it reflects the real state of a company’s finances less accurately. With a focus on cash transactions, Cash accounting does not distinguish between types of revenue or account for non-cash items such as depreciation. It is used primarily by wholesalers, retailers, and service providers.

Advantages of Cash Accounting

Now, let’s look at the advantages of the cash accounting method.

Simplicity. Cash accounting is the most straightforward accounting method.

Easy to track actual profit and loss. Cash accounting records revenue and expenses when payment has been made or received, enabling business owners to track their profit and loss with fewer adjustments.

 Facilitated identification of the drivers of business performance. Cash accounting makes it easy to identify which drivers of business performance are responsible for an increase or decrease in revenue. For example, if sales have decreased, the owners can look at their accounts receivable to see whether customers have paid their bills. If sales have increased, they can look at the accounts receivable to see when those customers paid their bills. This identification can make it easier for business owners to understand why their sales have changed.

Disadvantages of Cash Accounting

You might also want to know the disadvantages of the cash method before you finally select it for your business. The most significant are as follows:

Cash accounting does not distinguish between different types of revenue. Revenue from different sales channels, products, or services gets to the books as one figure. This way, a business can’t tell which channel or product performs better or worse and decide on the necessary changes.

Cash accounting does not recognize expenses for non-cash items, such as depreciation, interest, and certain taxes. A company’s net income will be less than its actual profit because those items have not been deducted from revenue.Cash accounting makes it difficult to determine the true financial health of a company. With cash accounting, you only record income and expenses when the money was paid or received. This way, you might not consider the outstanding payments that you expect to receive in one of the next months from the goods and services you sold in the current period. It might create a false impression of a business being less profitable than it is.

How to Decide Which Accounting Method is Right For Your Business

Understanding the difference between cash and accrual accounting is the first step in choosing which method could suit you. Before you finally choose the accounting method to go with, you might want to consider other factors that might influence your decision. Let’s look at them.

Accounting software

The type of accounting software that you use can already play in favor of this or that accounting method. Some work best with cash accounting, while other software is better suited for accrual accounting. If you are unsure which accounting method will work best with your software, you may ask your accountant for advice.

Business financial situation

The financial situation of a business might impact your decision. For example, early-stage companies that don’t yet generate significant revenue often choose to go with cash accounting, as it is less complex than accruals and gives a better view of the cash flow.

Industry-specific factors

Finally, a few industry-specific factors can impact your decision on which accounting method to use. For example, some industries might want to use cash accounting because it is easier to perform, meets auditing standards, or is more convenient to account for inventory. So if your industry requires you to use cash or accrual accounting, you might consider this requirement.

Conclusion

Selecting the accounting method is an important decision for any business owner. Thus, it’s crucial to understand the differences between cash and accrual accounting, the advantages and disadvantages. The decision can have a significant impact on your business’s financial health. Using the accounting method that fits you the best, you can manage your finances more efficiently and put yourself in a stronger position for future growth.

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Volha Belakurskaja

Volha Belakurskaja

Volha is an experienced copywriter with 10+ years experience writing for the information technology and services industry and a 5+ years sole proprietorship background. Passionate about all things tech, she is especially interested in topics lying at the confluence of business and technology.

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