Cash Basis Accounting vs. Accrual Basis Accounting
Cash basis accounting and accrual basis accounting are two methods used by businesses to record financial transactions.
The cash method of accounting, as its name implies, is based on the actual receipt and payment of money. So, a sale would be recognized only when the customer pays. And an expense would be recorded when the business makes payment to a supplier or an employee.
Accrual basis accounting is different. Accounting entries aren’t based on the receipt or payment of cash. Instead, accounting transactions are recorded when income is earned, or an expense is incurred.
So, for example, a company would recognize revenue on a credit sale when a product or service is provided to a customer even though payment could be made later. Similarly, the accrual method of accounting would recognize an expense for goods purchased on credit.
This post will discuss cash basis accounting and accrual basis accounting in a little more detail and compare the two methods to see how they differ. We’ll also examine which method of accounting businesses should adopt.
Cash basis accounting
We mentioned that an actual exchange of money is required to occur before an accounting transaction is recorded under this method of accounting. Let’s understand this point with an example.
Consider a company that sells a product for $100 on July 1. The sale is completed on this date, and the customer takes delivery of the product. But payment is made a month later, on August 1.
When will the seller recognize the revenue from this sale?
As cash basis accounting is being used, the accounting entry will be recorded only on August 1. The fact that the sale took place a month earlier will not affect the accounting date.
Expense recognition takes place in the same manner. A company that has adopted the cash method of accounting would recognize an expense only when it pays for it. So, if it purchases inventory, say in April, and pays for it three months later in July, it would recognize the purchase in its accounting records only in July.
As you can see, the cash method of accounting may not present a very accurate picture of a company’s financial state. Credit sales would go unrecorded, as would credit purchases.
This begs the question: Why do businesses use cash basis accounting?
The answer is that it’s primarily used only by some proprietorships and small businesses. They opt for this method because it’s simple and it helps entrepreneurs manage their cash effectively. However, if a company sells on credit or receives credit from its suppliers, the cash method may not be a very good option.
Accrual basis accounting
Most organizations use the accrual method of accounting. This method is superior to the cash method in many ways.
One of the foremost advantages of the accrual method is that revenue is recorded when it is earned, and expenses are recorded even if cash has not been paid for them. This ensures that a business matches its revenues with its expenses. Consequently, the accounting statements of a company present a precise record of its financial situation.
There’s another reason for using the accrual basis of accounting. The IRS stipulates that certain entities must use this method.
So, if your business is a corporation (other than an S corporation), with average annual gross receipts for the last three years of more than $25 million, it’s mandatory to use the accrual method.
Even if your revenue is less than $25 million per year, the IRS may require you to use the accrual method. Publication 538 titled, “Accounting Periods and Methods,” issued by the IRS, states: “Generally, if you produce, purchase, or sell merchandise, you must keep an inventory and use an accrual method for sales and purchases of merchandise.”
Here’s a comparison table that highlights the difference between the two accounting methods:
Cash Basis Accounting vs. Accrual Basis Accounting
|
|
Cash basis accounting |
Accrual basis accounting |
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Which types of businesses use this method? |
Typically used by small businesses |
Most large businesses use this method. IRS regulations make it mandatory for certain entities to use this method |
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When are revenues and expenses recognized and accounted for? |
When cash changes hands |
Revenue is accounted for when it is earned. Expenses are recorded when they occur |
|
Why use this method? |
It’s simple to use and allows entrepreneurs to track their cash balance closely |
It’s more accurate. Additionally, many businesses are required by the IRS to use this method |
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Does this method provide an accurate picture of a company’s financial position? |
No, it doesn’t, especially if you sell on credit or make credit purchases |
Yes, it does, as it matches revenues with expenses |
|
Should a business use this method? |
Use it only if you’re looking for a simple and easy-to-use accounting method |
For most organizations, this is a far better choice |
The bottom line
The cash basis of accounting is used primarily by sole proprietorships and small businesses. It’s a simple and effective method for maintaining your accounting records. Its primary advantage is its simplicity and that it allows you to keep close track of your cash position.
The accrual basis of accounting is more commonly used. Most large companies and publicly traded firms opt for this method. Additionally, even smaller firms that produce or deal in merchandise are required to use accrual accounting by the IRS.
