CASH AND ACCRUAL BASIS ACCOUNTING
Accrual accounting is when revenues and expenses are recognized and recorded as and when they occur; while cash basis accounting is when revenues and expenses aren’t documented or recognized until cash exchanges hands. By cash exchanging hand it simply means when cash is received or paid.
In accrual basis accounting, income is reported in the fiscal period it is earned, regardless of when it is received. Expenses are deducted in the fiscal period they are incurred, regardless of when they are paid. In other words, you record both revenue — accounts receivable—and expenses—accounts payable—when they occur. While in cash basis, income is reported when it is received and expenses are recognized when they are paid.
Accrual Basis Accounting vs. Cash Basis Accounting
The difference between the two types of accounting is when revenues and expenses are recorded. In cash basis accounting, revenue is recorded when cash is received, and expenses are recorded when they are paid, regardless of when they were invoiced. To illustrate the difference between the two accounting methods take the example where a business sells a product and the customer pays by credit:
- Using accrual basis accounting, the revenue is recorded immediately.
- Using cash basis accounting, the revenue would not be recorded until the credit payment is received.
Similarly, if a business incurs an expense and pays by credit, in accrual accounting the expense is recorded immediately, rather than deferred until the credit payment is received under cash basis accounting.
Accrual basis accounting gives the most accurate picture of the financial state of your business.
The advantage of cash-based accounting is simplicity. It is much easier to manage cash flow in real-time by merely checking the bank balance rather than having to examine accounts receivable and accounts payable. Given that most businesses fail due to improper management of cash flow, businesses that use accrual accounting still need to perform cash flow analysis.
Cash Basis Accounting
- Revenue is recorded when payment is received.
- Cash flow is managed in real time.
- Provides a point-in-time picture of a business’s cash flow.
Accrual Basis Accounting
- Revenue is recorded immediately.
- Cash flow is managed by checking accounts receivable against accounts payable.
- Gives a more accurate picture of the longer-term state of a business.
The Advantages of Accrual Accounting
While cash-based accounting can give a point-in-time picture of the business cash flow, accrual-based accounting offers a more accurate picture of the longer-term state of the business; revenues and expenses are immediately recorded, allowing the business to more properly analyze trends and manage finances.
Accrual accounting makes it easier to match revenues with expenses. For example, if as a contractor you paid for $10,000 in construction materials for a project in December, finished the job in the same month, but did not receive payment until the following February, using cash accounting, your books would show a large loss for the period ending in December but a large profit for the following period that includes February. With accrual accounting, you would book the revenue from the job in December, the same month that you paid for the construction materials.
Among the other advantages of using business accounting software, using an accounting software package can greatly simplify accrual accounting.
Tax Implications of Accrual vs. Cash Accounting
Whether your business uses accrual or cash accounting can have a significant effect on taxation. For example, if your fiscal year is the end of December and your business invoices a customer for $20,000 in November of the current year but does not receive payment until January of the following year, under the accrual method, the $20,000 would be included as revenue in the current taxation year; whereas using the cash method, the $10,000 would be included in the following year.
Which Method Should Your Business Use?
Many sole proprietorships and small businesses use cash basis accounting; however, accrual basis accounting is the method of accounting business that extends credit to customers, as cash accounting has no facility to track customer monies owed on an account.
Most incorporated businesses use the accrual method. Public companies that trade shares on stock exchanges are required to follow generally accepted accounting principles (GAAP), which require accrual-based accounting, as investors want the most accurate picture possible of the state of a company’s finances. If in doubt, check with your accountant or consult a professional as to which method you should use.
- In cash basis accounting, revenue is recorded when cash is received, and expenses are recorded when they are paid, regardless of when they were invoiced while in accrual basis accounting, income is reported in the fiscal period it is earned, regardless of when it is received. Expenses are deducted in the fiscal period they are incurred, regardless of when they are paid.
- The accrual method is the most commonly used method, especially by publicly-traded companies as it smoothens out earnings over time.
- The difference between cash and accrual accounting lies in the timing of when sales and purchases are recorded in your accounts. Cash accounting recognizes revenue and expenses only when money changes hands, but accrual accounting recognizes revenue when it’s earned, and expenses when they’re billed (but not paid).
The bottom line is that most companies will have to switch from cash to accrual accounting once the business grows to a certain scale to comply with the tax code.
How to convert cash basis to accrual basis accounting
- Add accrued Add back all expenses for which the company has received a benefit but has not yet paid the supplier or employee. …
- Subtract cash …
- Add prepaid expenses. …
- Add accounts receivable. …
- Subtract cash …
- Subtract customer prepayments.
To convert to accrual, subtract cash payments that pertain to the last accounting period. By moving these cash payments to the previous period, you reduce the current period’s beginning retained earnings. Cash receipts received during the current period might need to be subtracted.
Which is better cash basis or accrual basis?
While the accrual basis of accounting provides a better long-term view of your finances, the cash method gives you a better picture of the funds in your bank account. This is because the accrual method accounts for money that’s yet to come in.
It may also interest you to know that there is what we call the Hybrid Accounting.
The hybrid method is a combination of the cash and accrual methods of accounting. The IRS says, you can generally use any combination of cash, accrual, and special methods of accounting if the combination clearly reflects your income and you use it consistently. Hybrid basis of accounting is the system in which we use both cash basis and accrual basis of accounting. … By doing this, this system will become mixed system of accounting which is known as hybrid basis of accounting. This system can also used when your outside income will very low.