The timing of when revenue and expenses are recognized is the main distinction between accrual and cash basis accounting. While the accrual method focuses on anticipated revenue and expenses, the cash method offers immediate recognition of revenue and expenses.
When actual payments are made or received, revenue and expenses are recorded using the cash basis of accounting. It does not take into consideration the timing of the transactions that generate them. Contrarily, accrual accounting records revenue and expenses as they occur, prior to any cash being received or disbursed.
Accrual Accounting
In this method, revenue is recorded as soon as it is earned. The accrual method, as opposed to the cash method, records revenue when a good or service is provided to a customer with the expectation that payment will be made later. In other words, funds are tracked before they are received. Similar to this, costs for goods and services are noted before any money is spent on them.
Cash Basis Accounting
According to this method, revenue is only recorded on the income statement upon receipt of cash. Only when money is paid out in cash, expenses are recorded. Small businesses and individuals frequently use the cash method for personal finances.
Accrual Accounting V/s Cash Basis
Accounting Accrual Method
The accrual method keeps track of accounts receivable and payable, which can give a more accurate picture of a company’s profitability over the long term.
For instance, a business may have sales in the current quarter that the cash method would not record. The subsequent quarter is when the related revenue is anticipated. Investors may believe a company is not profitable even though it is actually doing well.
Cash flow is not monitored by the accrual method. In the long run, a business may appear to be profitable, but in the short run, it may be experiencing a difficult, significant cash shortage.
The need to account for things like unearned revenue and prepaid expenses makes the accrual method more difficult to use, which is another drawback. Additional staff may be needed as well.
In accordance with generally accepted accounting principles (GAAP) established by the Financial Accounting Standards Boards (FASB) , the accrual method is typically required for businesses that submit audited financial statements.
Cash Basis Method
The simplicity of the cash method, which only records cash paid or received, is its main benefit. The monitoring of a company’s cash flow is also made easier.
It is advantageous to small businesses and sole proprietorships because, most likely, it won’t require additional staff (and the associated costs) to use.
The cash basis method, however, might exaggerate a company’s health if it has a lot of cash on hand. This is due to the fact that it does not record any accounts payables that may exceed the cash on hand and the current revenue stream of the business.
As a result, an investor may believe the company is profitable when, in fact, it may be having financial problems.
Under GAAP, the cash basis method is unacceptable.
Special Considerations
The accrual method is the one that is used the most frequently, especially by publicly traded businesses. The accrual method is popular because it accounts for all revenues and expenses as they are incurred, which smooths out earnings over time. The cash basis method can present more frequently changing views of profitability because it only records these when cash is exchanged.
For instance, retailers would appear extremely profitable in Q4 under the cash basis method, as people make purchases in preparation for the holiday season. However, they would appear unprofitable in the first quarter of the following year as consumer spending falls off after the holiday rush.
Conclusion
Both approaches have benefits and drawbacks. Each offers various perspectives on a company’s financial situation. When making investment decisions, it’s crucial for investors to comprehend the implications of both strategies.