The difference between cash basis and accrual basis accounting comes down to when you recognize income and expenses in relation to movement of cash. If you record income when you receive money, it’s cash basis. If you record income when you earn it, it’s accrual basis.
LET'S DEFINE THE TWO!
Cash Basis Accounting: is the practice of recording income when cash is received and recording expenses when cash is paid. This is commonly used by individuals and small businesses since it is easy and simple.
Accrual Basis Accounting: a method that records income when a sale is made and records expenses when a service or product is bought. Regardless of whether cash has been received or paid.
BENEFITS OF CASH ACCOUNTING
- Cash Accounting is simple, and easy to maintain
- Lets you see how much cash is actually on hand
- If allowed for tax purposes, it allows you to pay taxes only on the money you’ve received
DISADVANTAGES OF CASH BASIS ACCOUNTING
- It’s less accurate. You do not account for liabilities/unpaid accounts as part of your expenses, and do not count receivables from your customers as part of your income.
- There is no audit of outstanding transactions, as cash basis only reflects actual cash paid and actual cash received.
- Sometimes, it’s not enough for making management decisions as you only see limited information about your business
- Not all businesses can use it or allowed to use it
WHO CAN USE CASH BASIS ACCOUNTING?
- Small businesses
- Businesses with lower than $25 million in sales for three years
- Businesses without inventory
BENEFITS OF ACCRUAL ACCOUNTING
- It’s highly accurate. It gives you a clear picture of your financial assets, liabilities, income and expenses. All types of financial transactions can be accurately recorded using accrual accounting method
- You will be able to see actual profits and strategize the business to improve revenue.
- Helps you predict the future flow of money coming in and coming out, so it’s easier to manage business finances.
- GAAP Compliant. It’s the method required by GAAP. It’s specially helpful if you view your business to grow in the future.
DISADVANTAGES OF ACCRUAL BASIS ACCOUNTING
- More challenging, more work, and expect more costs on maintaining the books
- Switching to accrual accounting is hard. You need to educate yourself with the ins and outs of accrual method of accounting
- Can expose your business to internal fraud. Since transactions are not purely based on actual money. Records could be manipulated and intentionally made inaccurate. Having strong internal control system will help avoid this issue.
WHO CAN USE ACCRUAL ACCOUNTING?
- Required: Businesses with gross sales higher than the IRS requirements
- Required: Businesses with inventory
- Required: Businesses that sell products/services on credit
- Optional: Small businesses can use accrual method but must stick to it once chosen