Cash and accrual accounting are like sibling rivals in the accounting realm—one clashes with the other, but you can definitely see the resemblance. Even if you don’t handle your own financial reporting, it’s vital to know how each one works so you can choose the best bookkeeping practices for your business. Show
Overview: What is the difference between cash and accrual accounting?Cash accounting records income and expenses as they are billed and paid. With accrual accounting, you record income and expenses as they are billed and earned. As long as your sales are less than $25 million per year, you’re free to use either the cash basis accounting or accrual method of accounting. Why should you choose one over the other? We’ll explain the basics of the cash accounting and accrual accounting methods, as well as the pros and cons of each so that you can make an informed decision. What is cash basis accounting?Let’s begin with cash basis accounting. With this method, you record income as it’s received and expenses as they’re paid. Cash basis accounting only records your expenses when money leaves your account to pay suppliers, vendors, and other third parties. In other words, if you have a small stationery business that purchased paper supplies on credit in June, but didn’t actually pay the bill until July, you would record those supplies as a July expense. It’s important to note that this method does not take into account any accounts receivable or accounts payable. This is because it only applies to payments from clients—in the form of cash, checks, credit card receipts, or gross receipts—when payment is received. Who uses cash basis accounting?Because of its simplicity, many small businesses and sole proprietors use the cash basis method as their primary method of accounting. If your business makes less than $25 million in annual sales and does not sell merchandise directly to consumers, the cash basis method might be the best choice for you. Some of the benefits include:
Example of accrual accountingUsing the example from above, if a small business bills a client $1,000 on March 1, you would record that $1,000 as income in March’s bookkeeping—even if the funds didn’t clear your account until April 15.
The same holds true for accrued expenses. In this case, if your small stationery business buys paper supplies on a credit card in June, but doesn’t actually pay that bill until July, you would still record that as a June expense. Let’s break this down:
Accrual vs. cash basis: Which is better?Accrual accounting is the winner if you’re looking solely at popularity, as it’s the most widely used as well as the most accurate when it comes to portraying a holistic view of a company's financial health. Cash basis accounting is still a popular option, however, due to the simplicity of the overall process. Advantages and disadvantages of accrual accountingUnlike cash basis accounting, which provides a clear short-term vision of a company’s financial situation, accrual basis accounting gives you a more long-term view of how your company is faring. This is because accrual accounting gives an accurate picture of how much money you earned and spent within a specified time period, providing a clearer gauge of when business speeds up and slows down over the course of a business quarter or a full year. Additionally, it conforms to nationally accepted accounting standards. This means that if your business were to grow, your method of accounting would not need to change. Advantages:
Disadvantages:
Advantages and disadvantages of cash basis accountingThe cash method of accounting certainly has its benefits, including ease of use and improved cash flow. While the cash basis method of accounting is definitely the simpler option of the two most common accounting methods, it has its drawbacks as well. Advantages:
Disadvantages:
How to choose the right option for your businessFor small companies that do business primarily through cash transactions and do not maintain large inventories of products, the cash accounting method can be a convenient and reliable way to keep tabs on revenue and expenses without the need for a great deal of bookkeeping. However, for the most accurate and updated accounting view of your financial health, accrual accounting might be the better choice. There are also some other factors to keep in mind. The complexity of your businessDepending on your industry and the complexity of your books, one accounting method may be more sustainable than the other. For example, a business with multiple accounts, hundreds of employees, and various LLCs will probably want to stay away from cash basis accounting because it won’t give the company the big picture view it’s looking for when it comes to financials on the income statement, balance sheet or cash flow statement. Sales revenueAnother reason to choose one over the other would be based on your sales revenue. According to GAAP, if you exceed $25 million in annual revenue, then you are required to use the accrual method. For many small businesses, this isn’t an issue at the moment but maybe in the future, so it’s something to keep in mind. Publicly TradedHaving a publicly-traded company or one that may go public is another stipulation of the GAAP guidelines. Publicly traded companies have a duty to report an accurate view of their financial well-being to shareholders. The best method for this is the accrual system of accounting. Moving forwardBefore moving along through your small business accounting checklist, understanding which accounting method to use is, without a doubt, an imperative decision for your business. That’s not to say it can’t be changed later—only that it’s harder to switch once you get comfortable with one way or the other. Accounting software and tools like QuickBooks Live can help with either method, with virtual accountants available to help you every step of the way. Bottom line, whether you choose cash or accrual accounting, remember to understand both options and stay within compliance with GAAP for your state. What method of accounting records income when it is earned and expenses when they're incurred?Accrual accounting recognizes revenue when it's earned and expenses when they're incurred, regardless of when money actually changes hands.
What type of accounting method recognizes revenue as soon as it is earned but not necessarily received?Accrual accounting is an accounting method that recognizes revenue in the period in which it's earned and realizable, but not necessarily when the cash is actually received. Similarly, expenses are recognized in the period in which the related revenue is recognized rather than when the related cash is paid.
Which accounting method is used when income or expenses are recognized regardless of related collection or payment?The accrual basis of accounting is the concept of recording revenues when earned and expenses as incurred. The use of this approach also impacts the balance sheet, where receivables or payables may be recorded even in the absence of an associated cash receipt or cash payment, respectively.
What are the two accounting methods for recognizing revenues and expenses?The two main accounting methods are cash accounting and accrual accounting. Cash accounting records revenues and expenses when they are received and paid. Accrual accounting records revenues and expenses when they occur. Generally accepted accounting principles (GAAP) requires accrual accounting.
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