The two primary methods used by businesses to record and account for financial transactions are cash basis accounting and accrual basis accounting.

Often times a business will start bookkeeping transactions using the cash basis method and will then graduate to accrual accounting. The reason for this is due to the simpler nature of cash basis accounting. That said, there is nothing wrong with using accrual accounting from the get-go - in fact - it provides a more complete picture of a company’s financial performance.

This post will explain the differences between cash basis accounting and accrual basis accounting so that you can determine which method is more appropriate for your business or startup.

CASH BASIS ACCOUNTING - WHAT IS IT?

In cash basis accounting, revenue is recognized when cash is received from customers, and expenses are recognized when cash is paid to suppliers or other parties. It means that transactions are recorded at the time of actual cash inflows and outflows, regardless of when the underlying economic activity occurred.

Here are additional details surrounding cash basis accounting and bookkeeping:

Revenue is recorded when the cash is received, not when the sale is made or the service is provided. For example, if a company sells a product or provides services in December but receives the cash payment in January, the revenue would be recognized in January under cash basis accounting. Under the accrual basis of accounting, revenue would be recognized in the month that the service occurred or product sold (December).
Expenses are recorded when cash is paid, not when the expense was incurred. For example, if a company purchases a product or uses a service in December but pays for it in January, the expense would be recognized in January under cash basis accounting. Under the accrual basis of accounting, the expense would be recognized in the month that the service occurred or product purchased (December).

CASH BASIS ACCOUNTING - ADVANTAGES

Cash basis accounting is straightforward as it follows the activity of cash inflows and outflows. It is commonly used by small businesses, sole proprietors and freelancers because it is simple to use and understand and doesn’t require complex adjustments.

From a bookkeeping perspective, a bookkeeper just follows the activity and transactions of the bank statement and credit card statement and records transactions into an accounting system based on when the transactions occurred on the statements.

CASH BASIS ACCOUNTING - LIMITATIONS

As businesses grow they eventually graduate to using accrual accounting as their method of recording transactions because it helps provide a more accurate picture of their financial performance.

Two key limitations related to cash basis accounting are:

Timing - cash basis accounting doesn’t reflect actual economic activity. As mentioned before, if a service was provided in December but cash was received in January, cash basis accounting would show revenue in January. But in reality, the revenue and services provided occurred in December. As such, a company might show high profits in one period due to receiving large cash payments, even if it had minimal sales during that period. Accrual basis accounting aims to match revenues and expenses to the periods that they occurred.
Financial Analysis - cash basis accounting usually does not provide a complete picture of a company’s financial position because it ignores accounts receivable, accounts payable and other accruals that provide insights into the company’s financial obligations and future cash flows.

ACCRUAL BASIS ACCOUNTING - WHAT IS IT?

In accrual basis accounting, revenues and expenses are recorded based on when they are earned or incurred - regardless of whether cash changed hands or not. Accrual basis accounting attempts to match revenues and expenses to their underlying economic activity. This method provides a more accurate representation of a company’s financial performance position over time.

Here are additional details surrounding cash basis accounting and bookkeeping:

Revenue is recorded when it is earned (not when cash is received). This typically happens when goods are shipped/delivered or services provided - despite not receiving payment for the goods or services. For example, if a company sells a product or provides services in December but receives the cash payment in January, the revenue would be recognized in December under accrual basis accounting (as opposed to January under the cash basis accounting method).
Expenses are recorded when they are incurred (not when the cash is paid). This typically happens when an expense is consumed - despite not actually paying for the expense yet. For example, if a company purchases a product in December but pays for it in January, the expense would be recognized in December under accrual basis accounting (as opposed to January under the cash basis accounting method).

ACCRUAL BASIS ACCOUNTING - ADVANTAGES

One of the core principles of accrual accounting is the ‘matching principle’, which aims to match revenues with the expenses incurred to generate those revenues in the same accounting period. This ensures that financial statements reflect the true cost of earning the revenue.

By adhering to the matching principle, financial statements provide a more comprehensive overview of a company’s financial performance. In addition to the matching principle, accrual basis accounting takes into account a company’s accounts receivable, accounts payable and other accruals (i.e. any other revenues or expenses that should be reflected in a certain period whether or not cash has been received/paid).

Accrual basis accounting provides more transparency surrounding a company’s financial operations and provides business owners with the ability to make faster and smarter decisions.

ACCRUAL BASIS ACCOUNTING - LIMITATIONS

Adhering to accounting standards related to accrual basis accounting requires more effort and accounting knowledge, education and experience. To ensure that financial statements are consistent with accrual based accounting, an accounting system is usually required with invoicing, accounting receivables, accounts payables and adjusting entry capabilities. Although this method of accounting provides many insights, it does come with complexity.

Accrual basis accounting is usually too much of a burden for small businesses, sole proprietors and freelancers, which is why they may choose to bookkeep their transactions using the cash basis of accounting.

FINAL THOUGHTS

Cash basis accounting and accrual basis accounting differ in their approaches to revenue and expense recognition. While cash basis accounting may be simpler and suitable for small entities with straightforward financial activities, accrual basis accounting is generally preferred for its adherence to accounting standards, accuracy in reflecting financial performance, and comprehensive financial analysis. The choice between the two methods depends on the specific needs and requirements of the business or organization in question.

back

Featured