Since the time accountants learned to crunch numbers, they have been asked about the difference between the two methods of accounting a gazillion times. Pun aside, it clearly is something that confuses a lot of people.
The two accounting methods i.e., cash and accrual are quite different from each other in a lot of aspects. Both these methods account for the wealth that you or your business makes. They paint a clear picture of how your income looks after a sale or purchase is made. How the income appears depends on the method you use for accounting.
Before delving into the differences, let us first touch base with the two methods briefly.
In the cash method, the revenues get recognized or simply to say recorded as soon as the cash is received. The sale may be made a week ago but it is only upon receiving its payment that it becomes part of the revenue. Accounts receivable, as well as accounts payable, are not recognized in this method of accounting.
The cash method is very straightforward as it can tell you how much money you have at your disposal. Since it does not recognize accounts payable and accounts receivable, you have one less thing to keep a track of. Small businesses usually opt for a cash method as it is convenient and not as complex. Further, small businesses can also take a calculated risk if there’s a need for it knowing how much they can expend.
The accrual method is a tad bit complex compared to the cash method which is pretty straightforward. In the accrual method of accounting, the revenues and expenses get recognized as soon as the sale or purchase is made. The cash may get processed weeks later but as soon as the sale or purchase is done, it gets recorded into the income. Therefore, accounts receivable and accounts payable are recorded in this method of accounting.
The accrual method is ideal to have an idea about the bigger picture of a company’s income. It gives you insights into how much income has been generated in a given period of time. The company can make informed decisions about what they would want to do with the income in the long term. Generally, companies with a lot of cash flow like multinational companies or well-established businesses use the accrual basis of accounting.
The key differences between the two methods include the following:
- Cash based method of accounting gives a day-to-day picture of the overall income of the company while you can look at the overall revenue the company made in a given period using accrual method.
- When it comes to tax payment, if the company is using a cash-based method tax will only be applicable on the money in the account not on the accounts receivable or payable. In case of accrual method, tax will apply to all the money that you owe or are owed.
- Keeping a record of the bank account suffices for the cash method while tracking down all of the invoices additional to the bank account is mandatory for the accrual method.
How the income appears
One of the most commonly experienced confusions by the companies related to accounts is the disparity between their bank account and what the accountant tells them. While an accountant may tell you that you did great in terms of the profit this quarter, your bank statement may not agree with it. This has a lot to do with the type of accounting method that you are working with.
For instance, if your company uses a cash-based method, you may be paying the bills of the previous months that came in this particular month. Since the revenue is only recorded when the cash is received, regardless of how much profit you might have made the same month, it might not be reflected in your bank statement because of the previous dues or fees you either paid or received this month. The same is the case with loss.
While for the accrual method, you have accounts payable and receivable right in front of you so you can have a much clearer idea of how much you made or lost during a quarter. It tells you the situation of your financials after calculating the amount you owe and are owed within a specific period of time.
In a nutshell, the two methods are strikingly different from each other. Whether a business wants to opt for a cash method or the accrual one depends on the size of the income it generates. While both the methods have their own benefits and drawbacks, it is up to the company to decide which means of accounting they want to go for.
Keep coming back to this space for more details!