Cash vs. Accrual Accounting: Which One Fits Best for You?
Your income taxes depend upon your profit reports. Your profit reports depend upon the type of accounting you choose, accrual accounting, cash accounting, it could be any, and it impacts your investment raising capabilities or loan obtaining capacity.
You can not choose between the type of accounting you want to work with each year as the other accounting options; you need to make a serious decision and stick to that.
Difference Between Cash Accounting and Accrual Accounting
- Each accounting method shapes how you will record the transactions and how you will report it.
- In cash accounting, you only record cash in hand in the transactions; Whereas in accrual accounting, you document transactions related to your accrual income and expenses.
- To understand which method will suit you, let us discuss the advantages and disadvantages of both.
What Is Recording Transaction?
We have used the term "recording transactions" so far several times, and cash accounting, accrual accounting both depict "when" you do your accounting.
But it still raises a question, what is "recording a transaction."
Each business is supposed to record its transactions in a register, also known as bookkeeping. It is essential if the owner wants a tax deduction by the end of the year.
You can either do your bookkeeping yourself or hire a bookkeeping expert to do it for you.
What Is Cash Accounting?
Cash accounting does not acknowledge the amount payable and receivable, but they received cash as income and paid money as an expense.
Most small firms prefer to use a cash basis of accounting as it is easy to maintain and recognize when the cash has been received and paid.
Features Of Cash Accounting
- Identifies the cash in hand as the income received.
- Identifies when the business spends cash in hand as the expense.
- The business is not supposed to pay taxes on the income not received yet.
- Sole proprietors and small businesses mostly adopt it.
Where The Cash Accounting Is Used
- Businesses that use a single entry system prefer cash accounting.
- A business where the credit-system is not accepted uses cash accounting.
- Businesses with small staff numbers prefer cash accounting.
- When a firm owns little or not so expensive assets or no support list, it prefers cash accounting.
Advantages Of Cash Accounting
- It is easy to understand for people with less education and knowledge about more complicated accountancy as a single entry system.
- No bookkeeping or training in accounting is needed to execute cash accounting.
- Cash accounting does not need any complex accounting software since it is straightforward to use and maintain. You can easily pen down transactions on a spreadsheet or a notebook.
- Cash accounting helps in maintaining the records of the cash in-flow and out-flow
Disadvantages Of Cash Accounting
- The results are less accurate in cash accounting as it does not provide the precise timing of the cash in-flow and out-flow.
- In cash accounting, one can easily show increased liabilities and influence the cash flow statement by not cashing out received cheques.
- Cash accounting does not produce accurate statements because of which lenders do not lend money to them quickly.
- Auditors might not accept cash account transactions.
- A company can not publish out their reports as the reports are entirely inaccurate.
- Owners can not rely on cash accounting for the evaluation of their firm's financial position.
- As cash accounting does not have an in-built error checking system, nobody might notice the error unless they do not obtain a bank statement showing an unforeseen low account balance.
Is Cash Accounting For You?
If you have a small business and do not have enough accounting knowledge and prefer an easy method to track your transactions, you can like cash accounting if you have limited staff or less or no inventory.
No need to hire a bookkeeper, no complications, simple transactions, and no complicated software needed.
What Is Accrual Basis of Accounting
When a firm earns income , it is recorded on the accrual basis of accounting, even if it is received or paid.
The accrual accounting methods give more of a realistic idea of the cash in-flow or the out-flow.
Features Of Accrual Accounting
- Identifies the earned revenue (example: when the project is complete)
- Identifies bills as an expense (example: when the business received a statement of charges)
- The business is supposed to pay taxes on the amount they are still about to receive.
- Firms with a turnover of more than $5 million use the accrual accounting method.
Where Accrual Basis Of Accounting Is Used
- Large companies with a high number of employees use accrual accounting.
- Enterprises that have inventories have to use accrual accounting.
- Businesses sell their goods and services in credit use accrual accounting.
Advantages Of Accrual Accounting
- Accrual accounting provides a clear perspective of all-inclusive business's cash flow statements.
- Investors prefer accrual accounting over cash accounting, as it shows pretty accurate cash flow statements. An enterprise that uses accrual accounting is often considered permanent.
- The Generally Accepted Accounting Principle prefer accrual accounting. The financial accounting standards boards set GAAP since the accrual accounting financial statements are pretty accurate.
Disadvantages Of Accrual Accounting
- Accrual accounting might need many staff or even an entire department to track down the company's financial records.
- Accrual accounting needs monthly reporting frequently; the company needs to generate continuous reports each month to be as accurate as possible. Balance due is the most frequent recorded transaction.
- Unlike cash accounting, accrual accounting records transactions of even those not even received yet; therefore, the company is supposed to pay taxes on the amount that is not even in its bank account.
So you have gained enough insight regarding cash vs. accrual accounting. So, which one you choose for your business?