Accrual Accounting vs Cash Accounting

Difference Between Accrual Accounting vs Cash Accounting

Timing is Important. From cricket to accounting timing plays an important role in all facets of life. Like a well-timed shot, timely recording of revenue and expenses plays a major role in your financial statements. There are two types of accounting – cash based, and accrual based. Let’s dive in further to understand these concepts.

Definitions

Cash accounting or Cash Basis is an accounting method that recognizes the expenses or revenues as and when payments are made for them. It is as simple as making a journal entry only when cash is received, or when bills are paid. A company might have made sales in a year but since the revenue was not received till the next year, the revenue from these sales might not be recorded until the payments are actually received. This method is employed mainly by small-scale enterprises or by individuals for personal finance. The method is in sync with the old saying – Don’t count your eggs before they are hatched.

This approach is in contrast to accrual accounting where, as the name suggests, the payments are accrued or accumulated. The revenues and liabilities are realized when they are incurred rather than when they are recorded. In simple terms, the journal entry would be logged even before there is an actual exchange of money i.e. income before the cash is received and expenses before the bills are paid. You deliver a service or product to the client and record the transactions with the anticipation that the payment would eventually be received from the other party.

Both Accrual Accounting vs Cash Accounting methods is like two sides of a coin. In the long term they don’t affect much but in short-term can provide huge differences to the statement of cash flows.

Accrual Accounting vs Cash Accounting Infographics

Below is the top 7 difference between Accrual Accounting vs Cash Accounting

Key Differences Between Accrual Accounting vs Cash Accounting

Both Accrual Accounting vs Cash Accounting are popular choices in the market; let us discuss some of the major Differences Between Accrual Accounting vs Cash Accounting:

The significant difference between the Accrual Accounting and Cash Accounting is where we started our discussion – Timing. The timing of recording or recognizing a transaction, whether Revenue or expenses. On one hand, the cash-based mechanism believes in instantaneous acknowledgment of the expenses and revenues, accrual-based method, on the other hand, emphasizes on anticipated transactions. Another vital difference is in the way cash is tracked. On its part cash-based accounting provides an exceptional view of cash flows recording inflows and outflows as and when they occur but lose out on matching revenues and expenses in the journal entry. Accrual accounting, on the other hand, is bad at tracking cash flows but great in matching revenue and expenses.

Nature

The cash accounting is simple and intuitive to understand. Income and expenditure are realized based on their occurrence. It does not really matter when the invoice was issued. Hence when a firm relies on cash-based accounting it does not need to prepare any adjustment entries like accruals, deferrals or prior period items.

Meeting GAAP

The cash accounting method relies more on the timing of the payments rather than when they were actually incurred. There might be a possibility that a firm would not record revenue in the year the corresponding work was done as the revenue was received a year later. It is not an acceptable form of accounting and hence it is not recognized by GAAP (Generally Accepted Accounting Principles). On the other hand, Accrual accounting is widely accepted because of the fact that it recognizes the revenues when they are earned rather than when they are received.

A better picture of financial performance

Relying on cash would be more of a crude and disorganized way of reporting transactions. The financial status thus reported will not be an accurate way of gauging the financial performance of a company considering there might be projects that run for a longer time horizon. It can be difficult and frustrating for investors to come up with a future projection of revenues and cash flows leading to second thoughts over their decision to invest in the company. Accrual is much more systematic, clean and acceptable way of accounting. The reliance is more on a holistic view and a single transaction (whether small or huge) does not have the capability to alter the financial status and performance of the firm. Thus, providing a true and fair view of financial statements.

Access to credit

As the business grows reliance on cash decreases and transactions rely more on credit. In fact more than the expansion of business, to survive in a competitive market, cash-based transactions are no longer sufficient. There will be times when payments will be delayed. In accrual accounting recording and measuring, credit can be easily done, a phenomenon unknown in cash accounting.

Tax implications

Whether you use accrual or cash mechanism of accounting, it can have a substantial impact on your tax statements. For example, say you receive a payment in January (start of the fiscal year) for the services provided in Q4 (end of the previous fiscal year) for a sum of $ 5000. Cash accounting would include this amount as revenue in the current fiscal year which would inflate your tax for the current year. However, accrual accounting would consider this amount in the previous fiscal year itself even though the payment was not received then.

Head To Head Comparisons Between Accrual Accounting vs Cash Accounting

Below Is The Topmost Comparison Between Accrual Accounting vs Cash Accounting

Accrual Accounting vs Cash Accounting – Final Thoughts

For its simplicity, easy implementation, less time consuming and an easier interpretation, Cash accounting is acceptable for small enterprises (having less than $ 5 million in sales). The payments can be easily accounted and complex accounting mechanisms like deferrals and accruals can be avoided. However, since there is too much dependence on the transactions, a single payment from the client can result in unusually high or low profits in a particular quarter because of its sheer size or random timing. This very nature makes cash accounting difficult for publicly traded companies.  As the size of the firm becomes large and transactions based on credit increases, accrual accounting is no longer an option but a necessity. Hence it would be in the interest of SME and managers anticipating future growth to understand it so that the transition is smooth.

Recommended Article

This has a been a guide to the top differences between Accrual Accounting vs Cash Accounting. Here we also discuss the Accrual Accounting vs Cash Accounting key differences with infographics, and comparison table. You may also have a look at the following articles –

1. Accounting vs Financial Management
2. Top Differences Between Gross Income vs Net Income
3. Revenue vs Profit
4. Leveraged vs Unleveraged