Cash vs Accrual
Did you know that there are 2 methods that you can use to record and recognize financial transactions?
They are called the Cash Basis of Accounting, and the Accrual Basis of Accounting
There are key differences between each approach, and times in which it's more common to see one method being used vs the other.
Let's dive into it!
Cash Basis of Accounting
The Cash Basis of Accounting is pretty much like what it sounds like
It treats most deposits as income, and most withdrawals as expenses
Accrual Basis of Accounting
The Accrual Basis of Accounting works a bit differently
Here you focus on when income has been EARNED, and when expenses have been INCURRED
Income is earned whenever you officially deliver you product or service
Expenses are incurred whenever you consume the benefit of the expense
Can we go over an example?
Let's say you are reading a profit and loss, and it reads that in May 2023, there was $100,000 in revenue
Under the cash basis of accounting, that means that the company received $100,000 in it's bank account in May.2023.
This would be the case, even if the company hasn't shipped the product that the customers ordered, or even if they haven't performed any of the services that their customers paid for
If the company was reporting the Financial Statements under the Accrual Basis of Accounting, this would mean that the company earned this $100,000, IE they delivered the product or service to the customer.
This can be regardless of whether they already collected the money from the customer
Should I use the Cash Basis or the Accrual Basis?
It's up to you. Sort of.
You see, businesses have the opportunity to utilize either approach.
In fact, you can even find that on a tax return, where the Internal Revenue Service (IRS) will
ask you what basis you used:
But once certain events take place, they may be required to report under the Accrual Basis
When to report on the Accrual Basis of Accounting
Once a company is required to comply with Generally Accepted Accounting Principles (GAAP), they must report on the Accrual basis.
This is especially the case for Publicly Traded Companies, who are required to follow GAAP, and report under the Accrual basis.
It's also common to report to investors and shareholders under the accrual basis, since that basis gives the most insight into the true activities of the company.
Lastly, for tax reporting, you may be required to report under the accrual basis once you pass a certain threshold in assets or revenue.
When to report on the Cash Basis of Accounting
Smaller companies can benefit from asing the cash basis of accounting for one important reason: it's simple, and easy to reconcile.
Under the Cash Basis, you may be able to reconcile your books in a fraction of the amount of time that it would take to reconcile your books under the Accrual basis.
That's because the reconciling your books under the Cash Basis is very simple.
For the most part any money you receive is income, and any money that you pay is an expense.
There are some exceptions to tis rule (like inventory and fixed assets), but the general idea is that
it's a very simple approach for reporting."
The Accrual basis on the other hand requires you to record a number of adjust display what amount of income have been earned, and what amounts of expens incurred
Which do I prefer?
Well, it depends
If I was running a small company that had no outside investors, I would prefer to on the Cash Basis of Accounting. This would save me both time and effort
If my business were to grow, or take on outside capital. I may request to switch to of Accounting, since that method gives more visibility into what is actually taking business
Understanding the difference between Cash and Accrual accounting is a key thing
grow in your journey with Finance & Accounting.
Each has their own quirks, and time & place for when they should each be used.