Cash and accrual accounting are like two different rivals in a superhero movie—they clash with one another but are both equally important. These are the two main methods for recording business transactions. Each one has their own unique strong points and are meant to be used by its own set of businesses. The biggest difference between the two is when those transactions are logged. Even if you don’t handle your own financial records, it is important to know these for your finances.
Let us first start with Cash Accounting. With this method, your transactions are recorded when cash physically moves in or out of your business. As its name suggests, you record transactions as soon as you receive or pay cash. Cash basis accounting is easy to implement, maintain, and understand, which makes it ideal for small businesses or individuals. It also provides a, more or less, accurate balance of the company’s cash. Moreover, if you maintain your books on a cash basis, there will be little difference between your financial statements and your tax returns. This means your cash basis income statement can come pretty close to accurately mirroring your business’s cash flow statement. However, it is 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 when payment is received.
In other words, if you have a small business that sold on credit in December and only got paid in February, you would record that sale as a February revenue.
One downside of Cash Accounting is that your records may not accurately reflect the long-term financial health of a business. This is because it doesn’t account for receivables or payables.
Next, as for Accrual Accounting, this method tracks accruals, which could be unpaid expenses or invoices that customers haven’t paid yet. You record income when you earn it and expenses when they are used to produce that income. Accrual basis accounting can give you a more accurate picture of your business’s financial health because it takes your business’s unpaid expenses and your customers’ unpaid invoices into account. In the example above, the transaction would affect both your accounts receivable and income during the time of sale. You would no longer need to wait to be paid in order to recognize revenue.
Both methods has its own pros and cons. One of these is that while Cash-based accounting is a simple bookkeeping process that is similar to how you might track your personal finances, it may not show you an accurate picture of your financial health as it does record accounts receivable and payable. Small business owners may not be able to keep track of these income and expenses.
Choosing the right accounting method that would fit your business model is something that you must think about before starting operations. There is no one perfect list that could be used to help you pick out which is right for you. The business’ size, complexity of financial transactions, reporting requirements, and a lot more must be considered. Also, keep in mind that choosing one does not mean being stuck with it forever. It can be changed although the shift might be difficult and time-consuming. This is why it’s essential for businesses to choose the method that best fits their operational needs and reporting requirements.