In the realm of accounting, two predominant methods stand out: These are the accrual basis of accounting and the cash basis accounting. These approaches are applied depending on the business, its operation style, its level of financial complexity, as well as legal demands of the certain business. Both approaches are useful in keeping records of financial transactions, though they differ in timing and principles. Accounting training courses provided by the British Academy for Training and Development provides one with insights and knowledge about cash and accrual accounting and also aids in polishing one’s financial handling skills.
This article highlights what accrual and cash-basis accounting is and explains key differences between the two.
Accrual accounting is an accounting method whereby companies recognise revenues and expenses based on when the transaction is earned or incurred regardless of the cash position.
This means that it is translated using the actual economic activity as the basis of recording the transactions instead of cash basis.
For instance, if an organisation has performed a service in December, and it receives its cash in January, then the organisation will recognise the revenue in December. In the same way, expenses are recorded for the period in which they are made regardless of the time of payment.
This approach is more favourable as compared to the traditional approach since it reflects the current obligations of business and future revenue. The main variation between accrual-basis and cash-basis accounting lies in the time when the costs of an enterprise or incomes are reported.
Is ideal for presenting an accurate view of a company’s financial health.
Closely aligns the revenues with the expenses, thus providing better information on profitability.
Needed to meet most accounting standards (IFRS/GAAP).
It is complex to implement and requires expertise.
Includes monitoring of receivables and payables thus increasing administrative work.
Cash-basis accounting is a method in which the revenues and the expenses are recorded when cash has been paid out.
For example, in terms of recognition, revenue arises only when the money has been received while expenses are recognised only when the cash has been paid out.
This process is relatively easy and suitable for small businesses or for the one who needs to manage clear records. Although it is easy to apply, it cannot provide relevant information on the finance performance of an organisation especially those with a complex and large structure.
Easy to use and easy to manage for small businesses.
Minimises the need for complex monitoring and subsequent adjustments.
Gives a clear image of cash flow and availability.
Does not represent obligations or the upcoming revenues.
Distorts the financial performance during credit-heavy phases.
Non-compliance with IFRS or GAAP for big organisations.
When comparing accrual vs cash basis accounting, several distinctions emerge, making each method suitable for different types of businesses:
Accrual-basis accounting recognises the amounts when they are earned or due for expenditure, whether the cash is received or not. It achieves an accurate recording of financial activities in the period it is implemented thus providing an accurate picture of a company’s operations. On the other hand, cash-basis accounting only records revenue and expenses when money is exchanged, either for income to be received or for expenses to be paid. This makes cash accounting simpler but is also less accurate to the flow of the organisation’s financial operations in a certain time period.
Due to very little modifications needed, cash-based accounting is easier and more appropriate for small businesses, and it only records actual cash transactions. It is also much easier to understand and manage, especially for those who do not have a background in accounting. Accrual based accounting is a little complex because it requires the recognition of accounts receivable, accounts payable and adjustments among others to accurately reflect the financial obligations and revenues of the company. Extra work is required to accomplish the task, but it gives a clear view of the financial statement.
Accrual-basis accounting is required in many countries and accounting standards such as IFRS and GAAP, more so for large businesses, in preparation of compliant accounting statements of a business. This guarantees comparability and consistency of reports of various entities. Cash-basis accounting does not tally with the standards of such regulations, as such, it is not appropriate for businesses that have to follow these standards. However, it is still reasonable for any small-scale business not having rigid accounting reporting standards.
Accrual accounting provides a real representation of the financial performance of a business by linking the revenues to the expenses that were made in the process of generating them. It provides information on profitability and responsibilities in a certain period. While using cash accounting, it can give a deformed image of financial reports by removing receivables or payables, misinterpreting the true financial situation of the organisation, particularly in situations of significantly high credit transactions.
Accrual-basis accounting offers the means of recording the tax obligations at the time they are accrued without reference to the time of payment. This precisely ensures that taxes harmonise with the financial activity which created them, thus giving an accurate and clear financial position of an organisation. On the other hand, cash-basis accounting only acknowledges taxes when paid and thus different periods record huge amounts of accrued taxes. However, the accrual basis of accounting is more helpful for businesses with significant tax responsibilities, for the purpose of better financial planning.
The accrual-basis accounting places the inventory as part of COGS, that is cost of goods sold, showcasing expenses for which the inventory is used or sold. This helps to ensure that costs incurred on inventories match the revenue produced from their sale. While on the other hand, the cash basis of accounting recognises the inventory cost at the time when the inventory goods are bought.
These illustrate the difference between accrual basis accounting and cash basis accounting to determine which one fits best depending on the operation size and business goals.
The factors which determine which method between the accrual and cash basis accounting to be used depend on factors such as size of the business, complexity of the business and reporting requirements. Cash-basis accounting is sufficient for small businesses or sole proprietors because of its simplicity. However, accrual-basis accounting generally applies to large organisations that need to adhere to the set regulations.
In conclusion,
Businesses need to have an understanding of the difference between accrual-based accounting and cash-based accounting to enable them to make the right decisions. If you choose to use accrual accounting for accuracy or cash accounting to be easy, correctly choosing your accounting method with your business needs offers both transparency and compliance.
1. What is the difference between cash basis accounting and accrual basis accounting?
The only major difference, which sets the two apart, is the timing of when they record transactions. The accrual-basis accounting recognises revenues and costs when they are earned, while the cash-basis records only when costs are collected or paid.
2. What is an example of an accrual?
Accrual example includes for instance when a business receives a utility expense in December and pays for it in January. The expense is taken in December under accruals, meaning the period for which it was incurred.