Accounting is the backbone of any business. It is a systematic process of recording, analysing, and interpreting financial transactions. It provides a quantitative understanding of an organisation’s financial position and performance, playing a pivotal role in decision-making processes.
Cash-basis and accrual accounting are two methods of recording expenses and revenues in transactions. Understanding the distinctions is pivotal for accurate financial reporting and decision-making.
Cash Basis Accounting
Cash-basis accounting, also called cash receipts and disbursements or the cash method, emphasises cash flow and the amount of cash on hand. Simply put, this method records earnings and expenses when a business receives and pays money, respectively.
Cash-basis accounting is suitable for these types of businesses:
- Sole proprietors and small businesses: They often prefer cash-basis accounting due to its simplicity and ease of use.
- Businesses without inventory: Cash accounting can pose challenges in tracking inventory movement. However, businesses without inventory can use cash-basis accounting.
- Cash-only businesses: Although less common nowadays, businesses that solely accept cash can avoid credit-related liabilities.
However, there are certain drawbacks of using the cash method of accounting, that include:
- Lack of accuracy in portraying the timing of income and expenses
- Difficulty in understanding the current financial status of a business
- Potential omission of unpaid invoices, liabilities, and assets.
Accrual Accounting
Accrual accounting tracks revenue as it’s earned and expenses as they’re incurred, using accounts payable and accounts receivable to show the real-time financial status of your business. Accounts payable represent money owed to vendors, while accounts receivable represent money owed to your business.
Businesses using the accrual accounting method maintain accurate accounts payable and receivable records. Documentation includes dates of service, invoice generation, and payment. This method allows tracking of received payments, outstanding invoices, paid bills, and pending expenses or liabilities. It ensures up-to-date information and easy adjustments for each transaction.
Accrual accounting is crucial for larger businesses with complex financial operations. It is suitable for the following operations:
- Credit card payments: Unlike cash payments, accrual accounting accommodates delayed posting of credit-based statements.
- Asset and liability tracking: Accrual accounting allows businesses to record and differentiate assets (cash, checks, investments, inventory) and liabilities (unpaid expenses) accurately.
- GAAP compliance: Certain companies must adhere to GAAP standards, which require accrual-basis accounting.
Accrual accounting provides an accurate and unmanipulated financial overview. It ensures timely recording of all transactions and a precise evaluation of a business’s financial state.
Accrual bookkeeping, despite its trustworthiness, has some disadvantages as well:
- It is complex, requiring detailed record-keeping and may pose challenges for inexperienced users.
- It can be time and cost-intensive, necessitating outsourcing or software upgrades.
- Small businesses may find it challenging due to increased expenses and time investment.
Comparing Cash-Basis and Accrual Accounting
| Components | Cash-Basis Accounting | Accrual Accounting |
| Recognition of Revenue | Recognises revenue when money is received. | Records revenue when it is earned, regardless of when money is received |
| Expense Record | Records expenses when money is paid. | Records expenses when they are incurred, irrespective of monetary transactions |
| Tracking Transactions | Focuses on actual cash transactions. | Accounts for transactions when they occur, even if cash is not involved immediately |
| Documentation Type | Simpler for small businesses. | Provides a more accurate reflection of a business’s financial health but can be complex |
| Tax Requirements | Income and deductions are calculated in the year of actual payment or receipt. | Income and deductions are reported in the year they occurred. |
How Do You Choose Between Cash-Basis and Accrual Accounting?
When choosing between cash-basis and accrual accounting, consider factors such as business size, industry norms, gross receipts, inventory handling, financial consequences, and timing considerations. Small businesses often prefer a cash basis for simplicity, while larger enterprises may benefit from the accuracy of accrual accounting.
If a business deals with inventory, accrual accounting may better match revenue and expenses. Be mindful of the potential financial impact and whether the timing of transactions or a more immediate cash focus aligns better with the business model.
Summing Up
Accrual and cash-basis accounting both have unique advantages and disadvantages, cater to different business needs and are dictated by factors such as the size and budget of the company.
As such, a comprehensive understanding of both is imperative. A professional ACCA course is an excellent pathway to gain this crucial knowledge.
The Wallstreet School India offers a comprehensive ACCA Preparation Program, accredited by ACCA as an Approved Gold Learning Partner. This program enhances skills and strategies in accounting through industry-specific cases and well-researched study materials.
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FAQs
- What is an example of accrual bookkeeping?
One example of how accrual accounting is done is when an expense is incurred in January but paid in February. It is accrued in January on papers to ensure accurate recording.
- How is the cash basis calculated?
The cash basis is calculated as follows:
Net Profit + Depreciation + Non-cash Expenses.
- What are two examples of accruals?
Accrued expenses are the expenses a company incurs but has not paid yet. Utility expenses and property rental costs are two examples of accruals a company might need to track.
