Accrual vs. Cash Basis Accounting
What is the difference between cash and accrual accounting? The difference between cash and accrual accounting, the two types of accounting, is the timing of when transactions are recorded and when revenue is recognized.
Cash basis accounting is an accounting system that recognizes cash when received and bills when paid. Accrual basis accounting is an accounting system that recognizes revenue when it is earned and expenses when bills are received, regardless of when cash actually changes hands.
In accrual vs cash basis accounting, the accrual method is considered more accurate because it depicts what was actually earned versus what was owed in a given period. The information provided via the accrual method aids shareholders in evaluating business trends and overall profitability.
In regards to choosing which method to use, the cash method vs. the accrual method, most large corporations use the accrual method. Small businesses are more likely to use cash accounting than accrual accounting because it is simpler to implement.
What is Cash Basis?
The cash basis method of accounting only records transactions when the money is actually paid or received. Of the two types of accounting methods, the cash method is better than the accrual method at tracking cash inflows and outflows, but worse when matching revenues and expenses in a given accounting period. Cash accounting is easier to implement and is often used by small business owners and individuals. Businesses using the cash basis of accounting can only accept cash, card, or check. They cannot have in-house financing, as that requires accounts receivable. Accounts receivable represents money that is owed to a firm but not yet paid. The business provided the good or service but has yet to receive the money for doing so. Accounts receivable are considered current assets and are listed on the balance sheet.
The cash basis provides a good, if somewhat inaccurate, snapshot of a company's short-term health. In the long term, however, the cash basis of accounting can paint an inaccurate picture of a company's health by either overestimating or underestimating the value. This is due to the fact the related expenses may be recognized in a different period than the revenues.
This method is not recognized under the Generally Accepted Accounting Principles, or GAAP. GAAP is a set of generally accepted accounting principles, as set forth by the United States Government, which regulate how companies are supposed to file their financial documents. From a tax standpoint, the cash basis of accounting is easier, as well, because income tax is only paid on money that the company physically has since the income would not have been recorded until then.
What is the Accrual Method?
What is the accrual method? The accrual basis definition includes recording transactions as soon as they are initiated, not waiting for the money to actually be received. Similarly, expenses are only recognized when the bill is received. The accrual method is beneficial in that it provides a better, more accurate method of matching a business's revenues and expenses in an accounting period, but does not track real-time cash inflows and outflows as well as the cash basis of accounting. Businesses using the accrual method are able to provide in-house financing and have accounts receivable. Moreover, the accrual basis also provides a company with a better understanding of its assets and liabilities. The accrual method provides a more accurate picture of a company's health in the long term but is ultimately more complicated and harder to use. Calculating a business's income tax under the accrual method involves the reporting of income the year it is earned and the deduction or capitalization of expenses in the year incurred. The accrual method matches income and expenses in the correct year better than the cash method.
Cash and Accrual Basis of Accounting Examples
A hypothetical business sells machinery. On the first of August, the company sells a machine totaling four thousand dollars. With the accrual basis of accounting example, the four thousand dollar purchase is recorded as revenue the instant the sale is made, even if the customer does not send payment until the twentieth of August. Under the same set of circumstances, but with the cash basis of accounting, the four thousand dollar sale would not be recognized as revenue until the twentieth, when the cash actually changed hands from the customer to the machine-selling business.
Say the same machinery business receives a one thousand three hundred dollar electric bill on the first day of every month. The business has a five-day grace period to pay the bill, and the accounting department typically sends the payment on the third. Under the cash method of accounting, the bill is not added to the books until the bill is actually paid, on the third. Under the accrual method of accounting, however, the one thousand three hundred dollar electric bill is recorded as an expense on the first, the day the bill was actually received.
As another accrual basis of accounting example, say a company delivers a product to a customer in the last month of the fiscal year. The customer will pay for it 32 days later, which falls in the next fiscal year. Although the company will not be paid for the delivery of the item until the next fiscal year, it recognizes the revenue from the delivery on the income statement for the current fiscal year. Moreover, the salesperson who sold the product and set up the delivery earned a commission when the sale was made. The commission expense will show up on the company's income statement for the current fiscal year. Due to the pay periods for this company, however, the salesperson will not receive their paycheck for a week.
The accrual basis of accounting can be converted to the cash basis of accounting, via an accrual to cash adjustment. The steps for an accrual to cash adjustment are as follows:
- Subtract accrued expenses if the accrual occurred because there was not an invoice from the supplier. Accruing is when revenue is recorded before payment has been received or when an incurred expense is recorded before the company pays it
- Subtract accounts receivable if the money was not received within the period.
- Subtract accounts payable if the money was not actually paid during the period.
- Shift sales forward to the following period in which the cash was actually received.
- Shift customer prepayments to be included in the period when the cash was actually paid.
- Shift prepayments to suppliers to the period in which the cash was paid.
What is the difference between cash and accrual accounting? The main difference between accrual vs cash basis accounting is the timing of transactions and the recognition of revenue. The cash basis of accounting records cash when it is in hand and expenses when they are paid. The accrual basis of accounting records cash when earned and expenses when received.
The cash basis is better at tracking cash flow, both inflows and outflows, but worse at matching revenues and expenses. The accrual method is the opposite; it is better at matching revenues and expenses, but worse at tracking real-time cash inflows and outflows. Accrual accounting is more complicated, and as such, more small business owners and individuals choose to use the cash method. Businesses using the cash method can only accept cash, cards, and checks, and no accounts receivable. On the other hand, businesses using the accrual method, are able to provide in-house financing as they have accounts receivable. The accrual basis of accounting can be converted to the cash basis using an accrual to cash adjustment.
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What are pros and cons of cash accounting or accrual accounting?
Both accrual vs cash basis accounting have different strengths. Cash accounting better tracks cash inflows and outflows in real time, but does not match revenues and expenses in an accounting period very well. Accrual accounting does not track inflows and outflows as well, but matches revenues and expenses better. Accrual accounting is more difficult and requires the company to offer credit or financing.
Is cash or accrual better for taxes?
For small businesses, the cash method is better because income is taxed in the year it's received, and the cash method ensures that a business has the funds it needs to pay its tax bill .The accrual method, however, matches income and expenses in the correct year better than the cash method. The difference between cash and accrual relies on the timing, including when taxes are filed.
How do you reconcile cash from accrual?
Cash can be reconciled from an accrual via an accrual to cash adjustment. The adjustment includes subtracting accrued expenses, accounts receivable, and accounts payable; and shifting prior period sale, customer prepayments, and prepayments to suppliers.
What is an example of accrual accounting?
Someone owns a book store. Their friend purchases $250 worth of books and charges them to the store account. Under the accrual method of accounting, this transaction is recorded the instant it occurs. Under the cash method, however, the transaction wouldn't be recognized until the friend actually paid the $250. The difference between cash and accrual is timing.
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