What is the Difference Between Cash Basis Accounting and Accrual-based Accounting?
Cash and accrual-based accounting are the two common types of accounting. Businesses must select one of the accounting methods to record transactions. The two accounting methods differ in terms of the timing of recording transactions.
If you are a small business owner, you must know the difference between cash and accrual-based accounting methods. In this blog post, we will delve in-depth into the two main accounting techniques.
Cash-based Accounting
Cash-based accounting method recognizes income and expenses when cash is transferred. The income is recognized when the business receives cash, while expenses are recognized when the business pays cash.
Accountants record transactions when money is received or paid with a cash-based accounting method.
You can better track the inflow and outflow of cash during a period with the cash-based accounting method. In contrast, the accrual-based accounting method is better at matching income and expenses during a period.
A cash-based accounting method is also simpler to implement compared to the accrual-based accounting method. This is the reason most outsourcing accounting firms recommend this method for small businesses.
A drawback of the cash-based accounting method is that it does not record accounts receivable and payable. Transactions are recorded only when a company receives or pays cash, check, or card.
Accounts receivable represent money that is owed by a company that is unpaid by customers. Contrarily, account payable represents money that is owed by vendors that are unpaid by the company. A company that deals with credit sales or purchases must keep a separate record of accounts receivable and payable.
Cash-based accounting method provides a better snapshot of the short-term health of a company. However, this accounting method can underestimate or overestimate financial health in the long run. This is because the cash-based accounting method records expenses and revenues in different periods.
A company may have a negative cash flow during a period. But it may not reflect the true financial position. That’s the reason the accounting method is not recognized by Generally Accepted Accounting Principles (GAAP).
GAAP are accounting principles introduced by the accounting bodies in the US. The standard specifies how companies should record financial transactions.
Benefits and Drawbacks of Cash-based Accounting
The cash-based accounting method has various benefits and drawbacks for small businesses.
Benefits
Cash-based accounting method makes it easy to prepare estimated tax statements. The reason is that income tax is paid on money received by a firm.
Implementing a cash-based accounting method is easier. It is easier to record transactions using this method. You don’t have to use any accounting software when you use this method for recording transactions.
Learning to use cash-based accounting methods is also easier. You have to track fewer financial-related data with this method. Recording transactions won’t take much time due to which you can focus more on your business.
Yet another benefit of the cash-based accounting method is that it allows you to easily see how much money the company has earned at a specific period. The method only records transactions when the company receives and pays cash. Future income and expenses aren’t accounted for when recording data.
Small businesses can all gain potential tax benefits when using this method of accounting. The accounting method that tracks when money is paid and received generally results in lower net profit.
You can more easily see how much cash your company has that can be utilized for business expansion. You also have more control over the transactions with cash-based accounting methods. With this method, you can have more control over the transactions which can result in efficient tax and cash management practices.
Moreover, you can control when cash is paid and received. You can delay receipt of money and pay early to lower the tax bill. In other words, the cash-based accounting method gives you control over the timing of the cash inflow and outflow.
You can slow down or speed up expenses and revenues by controlling the timing of recording transactions. This allows you to legally decrease your tax liability during a period.
Drawbacks
The cash-based accounting method also has certain disadvantages for small business owners.
One of the main disadvantages of this method is that you don’t have a clear picture of the financial position of your company. You won’t know about the money payable to vendors. This may result in making the wrong financial decision. You can decide to make a big purchase without regard to the debt owed by the company.
The cash-based accounting method only gives a short-term snapshot of the company’s financial position. You may not know the actual position of the company which creates difficulties in making the strategic decision for the company.
Cash-based accounting also has certain restrictions. You cannot use this method in the following cases.
- The gross receipts exceed IRS limits
- Purchase or sell goods or services on a credit
- Have a large inventory
Another disadvantage of the cash-based accounting method is that transferring to accrual-based accounting can be difficult. If your company grows, you will have to spend a lot of time and cost in switching from cash to an accrual-based accounting method.
When transferring from cash to an accrual-based method, you need to calculate and add prepaid and accrued expenses, account payables, and receivables. In addition, you have to subtract cash receipts, payments, and prepayments.
In addition, you should request the IRS to change the accounting method from cash to accrual-based accounting. Form 3115, Application for Change in Accounting Method must be submitted to the IRS for changing the accounting method.
With the cash-based accounting method, the revenues are recorded when customers make cash payments and expenses are recorded when you make cash payments. The accounting method does not track or acknowledge accounts payable or receivable. So, this method is not suitable for manufacturing firms that rely on inventories.
Cash-based accounting makes it difficult to estimate the financial position of a company. You will have a difficult time tracking payables and receivables with the cash-based accounting method.
Transitioning from cash to an accrual-based accounting method is also difficult. Accounting errors can occur when transferring accounts. Moreover, the IRS does not allow this method for companies whose gross revenues exceed a particular threshold.
What is the Accrual Method?
Accrual-based accounting method involves recording transactions as soon as expenses and income are realized. The accounting method involves recording income when they occur instead of when payment is received by the company. Similarly, the accounting method involves recording expenses as soon as they are realized instead of when the company makes payments to customers.
With the accrual-based method, the company does not wait for customers to make payments. The income is realized when bills are dispatched to customers. In addition, expenses are realized when a company receives the bill from customers.
Benefits and drawbacks of Accrual-based Accounting
Benefits
The accrual-based method is better than the cash-based accounting method as it results in a more accurate reflection of the financial position of a company. Businesses that use this method can know the amount due from customers and also the amount payable to vendors.
Companies that use accrual-based accounting methods can easily raise capital. Banks can easily gauge the financial capacity of a firm to repay the loan by looking at financial statements prepared using the cash-based accounting method.
With the accrual-based method, the tax is paid on income earned during a period rather than money received by a firm. The income and expenses are matched due to which the tax liability is more consistent when using accrual as opposed to the cash-based accounting methods.
The accrual-based accounting method records revenues and expenses in the year they occur. This results in a better reflection of the financial position of a company.
Most companies use accrual-based accounting methods. The method is used by both large and small businesses. Large companies with average revenues greater than $27 million in the previous three years have no other option than to use a cash-based accounting method to record transactions.
Accrual-based accounting is also more suitable for large firms with large inventories. Businesses can record credit sales and depreciation expenses when they select an accrual-based method for recording transactions.
Another benefit of the accrual-based accounting method is that it makes it easier to see actual revenues and expenses. In contrast, the cash-based accounting method only allows you to record cash received from and paid to another party.
You can more easily track receivables and payables with an accrual-based accounting method. The method allows you to see a full picture of the financial position of your company. You don’t just see the money that has been deposited into your account. Instead, you can also see the money that has been earned by your company.
Accrual-based accounting method provides a better reflection of the financial position of a company. You get a more detailed view of the company’s finances including receivables and payables. You can record depreciation on long-term assets.
Using an accrual-based accounting method also provides certain tax benefits. You can reduce the taxable income by accelerated depreciation. Moreover, companies incur tax liabilities for sales earlier as compared to cash-based accounting methods. This will even out the tax paid by the company during a period.
Drawbacks
Accrual-based accounting also has certain disadvantages. There are more rules to follow with this method. You have to record transactions by following the GAAP rules. GAAP has specified rules for different transactions.
In addition, recording transactions using the accrual method is time intensive. You must use accounting software to record transactions using this method. There are even rules regarding the types of businesses that can use this method for accounting purposes.
You will have to hire an outsourced booking firm if you decide to use an accrual-based accounting method. This is important otherwise you will find yourself spending more time accounting instead of focusing on the growth of your business.
Accrual-based accounting also does not accurately reflect the cash position of your company. You may have as much cash as shown in the books. You will be taxed even when you haven’t received cash from customers. This may require taking loans that can increase the operational cost.
Examples of Cash and Accrual-based Accounting Methods
You can better understand cash and accrual-based accounting methods by looking at the examples. Let’s suppose that you are an owner of a company that manufactures machinery.
You have sold 1.000 machines for $10,000 to a customer. You receive $5,000 in December 2022 and the remainder in February 2023.
Under the cash-based accounting method, you will make the following entries in December and February 2023.
December 2022
Cash 5,000
Sales 5,000
February 2022
Cash 5,000
Sales 5,000
However, you record the entire sales revenue of $10,000 in December 2022 under the accrual-based accounting method.
Accounts Receivable 10,000
Sales 10,000
When the customer makes the payment, you make the following entries under the accrual-based accounting method.
December 2022
Cash 5,000
Accounts Receivable 5,000
February 2022
Cash 5,000
Accounts Receivable 5,000
Recognizing income & expenses
Accrual-based accounting method recognizes income and expenses when the income and expense occur. With the accrual basis of accounting, the transfer of cash into or out of the business is not relevant for recording transactions.
The accrual-based accounting method results in a more accurate description of the financial position of a company. It depicts when income was earned and when a company owed to another during a particular period. This helps creditors, investors, and other agencies in evaluating the financial trends and profit position of a company.
Small businesses are likely to choose the cash-based accounting method as it is simple to implement. Small business owners will be more interested in the cash flow position of a company. So, the cash-based accounting method is more suitable for them.
An accrual-based accounting method is more appropriate for large corporations. They have to focus on long-term profitability for their shareholders. Therefore, accrual-based accounting is more suitable for large firms.
If your company deals with credit sales or purchases, you should consider an accrual-based accounting method. With this method, you can record transactions income and expenses when they occur resulting in a better picture of the financial position of your company.
You can record expenses and income when they happen with accrual-based accounting. In addition, the IRS has set certain restrictions on the use of cash-based accounting methods. A partnership or C-Corporation with average gross receipts of more than $27 million in the preceding three years must use accrual-based accounting as per IRS requirements.
IRS also requires companies that rely on inventories to use accrual-based accounting methods.
The best accounting method for a firm depends on various factors. A cash-based accounting method is generally suitable for small businesses. In addition, the method is also appropriate for companies that don’t carry a large inventory and the revenues are below $27 million.
Companies that carry a large inventory should select an accrual-based accounting method. Also, large companies with revenues exceeding $27 million must use this method for accounting purposes.
Small businesses that have set a high growth target should also consider an accrual-based accounting method. This is important since switching from a cash-based method to an accrual-based accounting method is difficult.
Companies that rely on credit sales should also use accrual-based accounting methods.
Considerations When Using Accrual-based Method
You need to use accounting software if you are using the accrual-based method for recording transactions. In addition, you should also comply with GAAP rules when using the accrual-based accounting method.
GAAP mandates that costs should be recorded in the time frame when they occur. The goal is to match the income generated with the expenses incurred in selling goods or services to the customers.
As per GAAP, employee wages are recorded during the week they work rather than at the end of the month. Moreover, revenue is acknowledged and recognized in the accounts at the time of sale rather than when customers make payments.
The accrual accounting method also requires that you prepare a profit and loss statement and balance sheet at the end of the period. You must also prepare a cash flow statement to know about the inflow and outflow of cash during a period.
Creating financial statements that comply with GAAP provides various benefits. It provides uniformity in reporting financial transactions. This results in uniformity in reporting transactions. The reports can help in comparing performance with other firms. The reports prepared in compliance with GAAP can also be accepted by all financial firms. This will help your company in getting the required funds to sustain your operations.
GAAP provides rules regarding the recognition of income and expenses. The sales must be recorded when goods are transferred, or services provided to the customer regardless of when payment is received from the customers. The accounts receivable account is created for each customer. The accounts receivable account is closed for a customer once he or she makes full payment due to the company.
The matching principle of GAPP specifies that the revenues of the firm must be matched with eh expenses. One example of the matching principle is depreciation. The cost of the asset is matched with the benefits received over a while.
An example of depreciation will further help in understanding the concept. Let’s suppose that you purchased machinery in cash for $10,000. The machinery is estimated to have a useful life of 10 years. The bookkeeper will calculate the depreciation expenses using the following straight-line formula.
Depreciation expenses = Cost / Estimated useful life
Using the above formula, the depreciation expenses of the machinery are calculated as $1,000. The depreciation expenses will be shown as an expense in the profit and loss statement. The book value of the asset will also be deducted each year by the depreciation amount.
GAAP is required for all public companies that are registered with the Securities and Exchange Commission (SEC). Companies that are not listed must also follow GAAP standards if they need external financing. Moreover, companies whose accounts need to be audited must also prepare accounts using an accrual-based accounting method in compliance with GAAP rules.
Conclusion
A cash-based accounting method is simple to implement. The accounting method involves recording transactions when cash is received and paid by a company. In contrast, the accrual-based accounting method involves tracking expenses and income as they occur rather than when monies change hands.
A cash-based accounting method is easier to implement and they are suitable for small businesses. But companies that rely mostly on inventory sales or credit sales must use accrual-based accounting methods.
Accrual-based accounting method involves recording income and expenses when the bills are received or sent. This is different from than cash-based accounting method that involves recording income and expenses only when cash is received or paid.
Accrual-based accounting method results in a more accurate representation of the company’s financial position. But the accounting method does not accurately depict the cash flow position of the company.
Using a particular accounting method will have an impact on the taxes paid to the IRS. With the accrual-based accounting method, the taxable amount will generally be higher at times of sale. This is because the method involves recording all sales incurred at the time of sending invoices. In contrast, the tax amount will be lower with the cash-based accounting method since the income is recorded partially depending on the amount received from customers.
The accrual-based accounting method recognizes transactions at the time they occur. Accountants follow the GAAP principle of conservatism when recording income and expenses. As per this rule, revenues are recognized when they are confirmed, while expenses are recognized when they are likely to occur. The conservative principal results in a better projection of the financial status of a company.
Contact Maxim Liberty for professional outsourced bookkeeping services. Our team of professional accountants can record transactions in compliance with GAAP rules. You can count on us for timely and accurate records of your financial transactions.
