Difference between Cash Basis and Accrual Basis of Accounting

As a business manager, nestling into any business requires wisdom to choose which accounting method to apply. The two fundamental methodologies are cash basis accounting and accrual accounting. Familiarizing oneself with these procedures enhances financial control. Each approach has its merits and drawbacks. In this blog, we will focus on both accounting methods. We will define their functioning, relate them, explain when to adopt either of them and the most likely reasons as to why big corporations lean towards adopting the accrual method of accounting.

What is Accrual Accounting, and How Does It Work?

Accrual accounting is the practice where revenue and expenditure are recorded as they are earned or incurred and not at the time money exchanges hands. Put differently, you only register income once it is earned as opposed to when one actually receives the payment.

How Accrual Accounting Works?

Revenue Recognition: A business recognizes revenue at the point of delivery of goods and services, whether or not settlements have been received. For illustration, take a scenario where your firm offers consultancy services in the month of December. If the client remits the payment in January, the earnings will still be recognised in the month of December.

Expense Recognition: Such costs are recorded in the accounting period in which they occur, thus not necessarily in the period they are paid. You incur an expense in December if you order the supplies in the previous month and only make the payment in the following month.

What goes into the constituents of Accrual Accounting? 

Matching Principle: This looks at the relationships and timing between expenses incurred and revenues earned. This is important because it illustrates the economic performance of the company for a particular period.

Complexity: Compared to cash basis, Accrual accounting is more complex. It is important to understand the timeframes involved in accounts payable and accounts receivable. This can be more time-consuming and extensive compared to the cash basis.

Financial Reporting: The application of accrual accounting is mandatory for many firms due to the Regulations of GAAP. This approach is adopted by firms that prepare financial statements for banks or potential equity investors.

What is Cash Basis Accounting, and How Does It Function?

According to cash basis accounting, there is no prior entry for expenses incurred or revenue earned until cash changes hands. You simply mean that transactions are booked whenever cash is received or paid out.

How does the Cash Basis Accounting Work?

Revenue Recognition: Revenue is only booked when payment is received. Say you render services in December but payment is done in the month of January. The revenue will be posted in January.

Expense Recognition: Expenses are only recorded when paid for. For instance, suppose you receive some goods in December and pay for them in January, the expense will be recorded in January.

Key Features of Cash Basis Accounting

Simplicity: The cash method of accounting is quite simple. This system is less complicated and easy to administer. This simply explains the reason why most small businesses and self-employed individuals opt to use this system.

Tax Reporting: This is usually less burdensome for tax compliance. You report the income only after it is received. This helps in enhancing the management of cash within the business.

Limited Financial Insight: Cash basis accounting is not comprehensive in assessing the state of health of your business. It does not factor in debtors and creditors.

How Do Accrual and Cash Basis Accounting Differ?

To make things clearer, let’s compare accrual and cash basis accounting side by side in a table:

Feature	Accrual Accounting	Cash Basis Accounting
Revenue Recognition	Recorded when earned	Recorded when cash is received
Expense Recognition	Recorded when incurred	Recorded when cash is paid
Complexity	More complex, and requires more records	Simpler and easier to maintain
Compliance	Generally required for GAAP	Not GAAP-compliant
Financial Insight	Offers a more accurate financial view	May misrepresent financial status
Tax Implications	Can complicate tax reporting	Simpler for tax reporting

When Should Businesses Use Each Accounting Method?

When to Use Accrual Accounting

Larger Companies: For instance, if your business is bigger in size and has to present its financial statements to investors in its capital or any institution offering loans, then accrual accounting will be the correct approach. It sheds more insight into your financial position.

Inventory Management: On the other hand, if there is inventory involved, the use of accrual basis accounting makes it easier to correlate the costs associated with the particular stock as well as the profits earned from selling it. This method provides a better picture of what stock is held, and its worth.

Long-Term Contracts: In case the business engages in projects or tenders that last for a couple of months or more, accrual accounting allows the company to spread the cost incurred in the project in relation to revenue generated from that project over the duration that the project will be active. Thus, one is able to see the worth of the project under consideration.

When to Use Cash Basis Accounting

Small Businesses: In small businesses and in the case of sole proprietors, cash basis accounting is recommended. In case you have minimal transactions, this is easier to control.

Service Providers: This is mainly applicable to those who are in the services business and are paid on the spot for their services, lifting the need for cash basis accounting. It’s uncomplicated and straight to the point.

Preference for Simplicity: If you would like to sidestep the technicalities of accrual accounting, then cash basis accounting is for you. It is not strict when it comes to keeping records.

Why is Accrual Accounting Generally Preferred by Larger Companies?

Larger companies often choose accrual accounting for several important reasons:

Financial Accuracy: Accrual accounting is a better way of understanding the actual economic position of a firm. It allows companies to manage their revenue and expenditure effectively over a given period.

Investment and Credit: Even Investors and banks prefer this kind of company. This is because it adheres to the provisions of GAAP and reflects the true picture of its profitability over the long run.

Operational Insights: For instance, in the case of large organizations, it would influence better decisions on operations management, so the resources can be better managed.

Compliance and Reporting: Companies that go public and those that are looking for investment are mostly highly geared in terms of gearing ratio and have to adhere also to strict financial reporting practices.

What are the Pros and Cons of Each Method?

Let’s take a closer look at the advantages and disadvantages of accrual and cash basis accounting in a simple table:

Method	Pros	Cons
Accrual Accounting	- Provides a complete picture of financial health	- More complex and time-consuming to maintain
	- Required for GAAP compliance	- Can lead to tax liability before cash is received
	- Better for long-term planning and analysis	- Requires tracking of receivables and payables
Cash Basis Accounting	- Simple and easy to understand	- Less accurate view of financial health
	- Good for small businesses and freelancers	- Not GAAP-compliant
	- Better for cash flow management	- Can distort income and expenses over time

Can You Use Both Cash and Accrual Accounting?

Yes, businesses can use a mix of both methods, known as the modified cash basis. This method allows you to combine the simplicity of cash basis accounting with some aspects of accrual accounting. For example, you can recognize long-term assets or liabilities while still keeping a simpler cash flow record.

However, be aware that the IRS has specific rules about which accounting method you can use. It’s always a good idea to talk to a financial advisor or accountant before deciding.

How Do These Methods Affect Financial Statements?

Balance Sheet:

Accrual Accounting: This method provides a complete view of your assets, liabilities, and equity. It includes accounts receivable (money owed to you) and accounts payable (money you owe).

Cash Basis Accounting: This method shows only cash transactions. It may leave out important outstanding debts or income, making your financial picture less complete.

Income Statement:

Accrual Accounting: This shows revenues and expenses based on when they are earned or incurred. It gives you a clearer picture of profitability over time.

Cash Basis Accounting: This only reflects cash transactions. As a result, it may not accurately represent your company’s profitability during a specific period.

What Impact Do They Have on Tax Reporting?

Your accounting method also impacts how you report taxes:

Accrual Accounting: With this method, businesses must report income when it is earned. This can result in paying taxes on income that has not yet been received. It may lead to fluctuating tax liabilities based on revenue recognition.

Cash Basis Accounting: Businesses pay taxes based on cash received. This can help with cash flow management since you defer income until you actually receive it. It allows for easier tax reporting overall.

However, keep in mind that some businesses might be required to use accrual accounting for tax purposes. This often depends on their size and industry.

How Can Outsourcing with Global FPO Help?

Outsourcing your accounting tasks to Global FPO can make your life a lot easier, no matter which accounting method you choose. Here’s how we can help:

Expertise: Our team understands the ins and outs of both accrual and cash basis accounting. We ensure that you stay compliant with all relevant regulations.

Time-Saving: When you outsource, you can focus on running your business. We take care of the details, allowing you to spend your time on what matters most.

Customized Solutions: We offer tailored accounting services based on your business’s needs. Whether you prefer cash or accrual accounting, we can help you set it up and maintain it.

Cost Efficiency: Hiring in-house accountants can be expensive. By outsourcing, you can reduce costs while still getting high-quality accounting services.

Making the Right Choice for Your Business

Choosing between accrual accounting and cash-based accounting is a big decision. It’s important to understand how each method works and what it means for your business. While cash basis accounting may be simpler and more straightforward, accrual accounting provides a more complete picture of your financial health. Larger companies often prefer accrual accounting for its accuracy and compliance with regulations.

Ultimately, the right choice depends on the size of your business, the complexity of your operations, and your financial reporting needs. If you’re unsure which method to choose, consulting with a financial professional can help you make the best decision.

By outsourcing your accounting needs to Global FPO, you can navigate the complexities of accounting while focusing on growing your business. Understanding these accounting methods will help you manage your finances better and support your business’s health for years to come.

FAQs 

What are the legal requirements for choosing between accrual and cash basis accounting?

Different countries have specific legal and tax regulations regarding which businesses must use accrual accounting. This often depends on the size and nature of the business.

Can a business switch from cash basis to accrual accounting?

Yes, businesses can switch accounting methods, but this requires IRS approval in the U.S. and may involve specific filing procedures.

What impact does the choice of accounting method have on loan applications?

Lenders may prefer accrual-based financial statements as they provide a more comprehensive view of a business’s long-term financial health.

Are there industry-specific accounting methods besides accrual and cash basis?

Some industries, like construction, may use other methods like the percentage of completion method or the completed contract method for accounting.

How does accrual accounting affect the timing of income tax payments?

Businesses using accrual accounting may have to pay taxes on income they haven't received, which can affect cash flow planning.