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Accrual vs. Cash Basis Accounting: Pros, Cons, and Distinctions

Accrual vs. Cash Basis Accounting: Pros, Cons, and Distinctions

Accrual and cash-based accounting are both methods for recording a business’s transactions. Accrual basis accounting is preferred by most business owners, but cash basis accounting may suit very small businesses.

In this article, we're going to clarify a fundamental accounting principle that often prompts discussion and is crucial to understand. This is something that everyone struggles with and even a challenge to accountants. It's the concept of accrual vs. cash basis accounting. You'll find these concepts with examples, pros and cons, and an in-depth explanation that helps you choose the method that best suits your business model. So let's get started.

Accrual vs. Cash Basis Accounting

Accrual basis accounting is considered to be a better method to follow than cash basis because there's so much information that you can extract from it.

Most businesses, when they're starting, tend to go for cash accounting because it's easier. But have you ever wondered how big companies like Apple, Google, and Amazon do their books? They all have one thing in common: they use the accrual basis accounting method.

In accrual basis accounting, revenues and expenses are recorded when they're earned, regardless of when the money is received or paid. This method recognizes the income and expenses when they're incurred.

On the other hand, with cash basis accounting, you record your revenue once you receive the cash and record your expenses when you pay that cash out. It's a simpler way to do your books, and that's the reason why it's an approach used by many small businesses and individuals for personal finance.

There is one big problem with cash basis accounting: it can be really hard to work out your business's profitability, especially when you want to determine how much profit you made at a specific period of time. This is because of the timing differences between when you recognize your revenue and expenses. The accrual basis accounting solves this issue by recognizing revenue as it's earned and recording expenses as they're incurred. It serves as the exclusive strategic method that accurately reflects the true nature of transactions, thereby providing the clearest visibility into operational effectiveness, forecasting, and other strategic efforts.

Examples of Accrual Basis and Cash Basis Accounting

Let's say you have a baking business and you're selling a cake. The ingredients for that cake cost you $10 to buy, and you sell the cake for $25, leaving you with a profit of $15.

Now, imagine you sell a cake to a customer on the 25th of February. The customer has 7-day payment terms, so you won't receive the cash until the 1st of March.

Under the cash basis accounting method, the revenue would be recognized on 1st March, because that's when you receive the cash. However, under accrual basis accounting, the revenue would be recognized on the 25th of February because that's when the transaction occurred and you physically handed over the cake to the customer.

Also, imagine that you baked the cake using ingredients purchased a month ago, in January. Under the cash basis accounting method, you would have recorded the expenses in January because that's when you paid cash for the ingredients. However, using an accrual basis, you would instead record that expense in February because that's when you sold the cake.

You can see that under the cash basis accounting method, you recorded a loss of $10 (ingredient cost) in January and a profit of $25 in March. This timing difference could cause a real headache if you want to review your performance in February because you won't see any profit there.

But accrual basis accounting solves this issue for you. You recorded both the revenue and expenses in February, so you can see a profit of $15 in February, just as you'd expect. Your revenue and expenses are aligned with each other in the same accounting period because in accrual basis accounting, we apply the matching principle.

The Matching Principle

The matching principle states that "revenue and all expenses incurred to generate that revenue need to be recognized in the same accounting period."

This is the key differentiator between accrual and cash basis accounting. The matching principle makes it easier for us to objectively analyze results because you can accurately measure your profit over time.

Accrual Basis Accounting Pros and Cons

First of all, as we just mentioned earlier, the accrual basis applies the matching principle, so a business's profitability can be accurately measured for specific periods. It also measures accounts receivable and payable, so you can build a picture of your financial position. Accrual basis accounting is accepted under Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS). So, it's possible to produce financial statements under these principles and standards.

On the other hand, however, accrual basis accounting doesn't explicitly track cash flow. So this needs to be calculated separately using the direct or indirect methods. It's also more complicated than the cash basis accounting method because you have to make estimates and assumptions. This can be unsuitable for small businesses; that's why many of them choose to adopt the cash basis method instead.

Cash Basis Accounting Pros and Cons

Cash basis accounting is a great way to record transactions for small businesses that mainly deal in cash. It's simple and easy to understand, so you don't need to look for an accountant to manage these processes.In addition, many countries accept this accounting method for tax purposes as long as your earnings are below a certain threshold. While cash basis accounting offers simplicity, it may not be the best choice for businesses with aspirations for growth, as it lacks the complexity needed to manage larger-scale operations effectively.

On the other hand, when we look at the drawbacks of cash basis accounting, we come to know that most businesses are much too complex to use this method. When you use cash accounting, you don't have an accurate way of recording your profits. So, there can be a huge fluctuation in your results. This is caused by recording income and expenses in separate accounting periods. In addition, you have no way of knowing your financial position because you aren't recording your payables and receivables. Finally, and this can be a clincher, cash basis accounting isn't allowed under GAAP or IFRS.

So, the cash basis accounting method can be a great way to record transactions if you have a small business that relies solely on cash. However, if your business has payables and receivables, or tracks inventory, this method probably won't work well for you because of timing differences between cash in and cash out. In this case, accrual basis accounting might best suit your needs.

When to Switch between Cash Accounting and Accrual Accounting?

The pros of cash basis accounting might be appealing for most startups, but there comes a time when they face the situation when the accrual accounting method becomes a more appropriate option for them. Let's have a look at some of the events that may encourage startups to change from cash to accrual accounting.

  • To become a publicly traded company: To change your business structure and make it a publicly traded company, you may require adherence to GAAP. These principles are based on accrual basis accounting. So, that's the time you need to switch from cash to accrual accounting method.
  • IRS Penalty: An IRS penalty can encourage a taxpayer to change from cash accounting to accrual accounting. The IRS penalizes a business when it's not using accounting methods consistently and when it's not filing the income properly.
  • Advanced Payments: A business should switch to accrual accounting when it is collecting prepayments or holding contracts for longer than a year.
  • Loan Application: If you're approaching a traditional bank for a loan, then they'll ask for accrual-based books. So if your startup needs funds to operate and you're looking to finance it through loans, then that's the time you need to switch to accrual basis accounting.

In conclusion, understanding the differences between accrual and cash-based accounting is crucial for any business owner. While cash basis offers simplicity, accrual basis provides a more accurate picture of financial performance over time, adhering to the matching principle. Each method has its pros and cons, making them suitable for different business models and stages. However, as a business evolves, there may come a time when transitioning to an accrual basis becomes necessary, particularly for compliance reasons or to obtain financing. Ultimately, the decision between these accounting methods depends on the unique needs and circumstances of each business.

Ready to optimize your accounting strategy?

At AdaptCFO, we've assisted companies of all sizes in navigating the best ways to manage their revenue and implement strategic approaches to the most suitable accounting methods. Whether you're just starting out or looking to refine your financial processes, our expert team is here to guide you through every step of the way. Contact us today to learn how we can help your business achieve its financial goals.

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