The major difference between accrual and cash basis accounting the timing for recording the revenues and the expenses. When using the Cash Accounting Method, your revenues and expenses are immediately recognized. In contrast, accrual accounting focuses on anticipated revenue and expenses.
- In Accrual Accounting the entries for revenue and expenses happen when they occur, whereas, in cash accounting, you wait until cash exchanges hands before you record them.
- Cash accounting is easier, but accrual accounting portrays a more accurate portrait of your company’s health by including accounts payable and accounts receivable.
- In Government Contracting, the accrual method is the most used.
Accrual Accounting Method
In accrual accounting when you have a sale you record the entry into the system. Even though you do not expect payment for a few days or weeks. Unlike the cash method, the accrual method records revenue when the customer received the product or service whether or not you have received payment for the product or service. Payment for the product or service happens at a later day. When you receive a bill for an expense, you enter it into the system immediately. Even if you have not written a check to pay the bill.
Cash Basis Accounting
You record cash on the income statement only after you receive it when using cash basis accounting. Also, the entry for payments on expenses happens when payment is made. This method is most often used by small businesses and for personal finances.
The key advantage of the cash method is that it is simple. It only accounts for cash paid or received. Tracking your cash flow is easier with this method. But a disadvantage of the cash method is that it might overstate the health of a cash-rich business but has large sums of accounts payables that far exceed the cash on the books and your company’s current revenue stream. Someone looking at the books might conclude that the company is making a profit when, in reality, the company is losing money. Meanwhile, the advantage of the accrual method is that it includes accounts receivables and payables. As a result, it provides a more accurate picture of the profitability of your company. Why? Because you record all revenues when earned and expenses when incurred in accrual accounting.
A company using the cash method might have sales in the current quarter that would not show up until the following quarter. Someone looking at the books might conclude that your business is not profitable when your business is doing well.
The accrual method does not track cash flow, and as a result, you may not account for major cash shortage in the short term, despite looking profitable in the long term. Another disadvantage of accrual accounting is more complicated to implement because you need to account for unearned revenue and prepaid expenses.
While both methods have their advantages and disadvantages, each only shows part of a company’s financial health. Understanding both the accrual method and its cash flow with the cash method is essential when making a business decision.
Example Cash and Accrual
You have a business that sells equipment. A piece of equipment is sold for $5,000 under the cash method. You will record the sale when you receive the money from the customer. Under the accrual method, the sale of $5,000 is immediately recorded as revenue, even if you receive the money a few days or weeks later.
The same principles apply to your expenses. You will only record your expenses once you pay the electric bill for $1,000 when using cash accounting. When using the accrual method, your electric bill ($1,000) gets expensed when you receive the bill.
It is essential to understand and select the right accounting method for your business. It is always best to reach out to your CPA for help in this matter. You do not want to change methods after you established your business and are halfway through the year.
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