As a business owner, you are probably aware that there are two main accounting systems: Cash Basis Accounting and Accrual Accounting. However, understanding the differences between them, including their advantages and disadvantages, is not so simple.
The primary difference between accrual and cash accounting is the timing of when revenue and expenses are recognized. For non-accountants, cash basis accounting is easier to understand because it is commonly used for personal finances and very small businesses. You pay a bill, you record it in your register, you receive a paycheck, you record it in your register. Basically, you recognize revenues and expenses when they are received or paid out.
The primary advantages of the Cash method are: it’s simple therefore making it less expensive to maintain, and it provides a clearer picture of how much cash a business has on hand.
Though Cash may be fine for a very small business, Accrual is the standard method of accounting used for most companies. The accrual method records a revenue or expense transaction when it occurs, not when money is actually received or paid. For example, a furniture store sells a livingroom set to a couple in February and does a “0 down, 90 days same as cash financing”, which the couple pays off in May. With the accrual method the sale amount is recorded in February even though no money was received until May. The same with an expense. If that same store purchases a new forklift on credit in February, but doesn’t receive and pay the bill until April, the expense is recorded in February.
So what are the advantages of the accrual method of accounting? One big advantage is that it gives a more accurate record to track sales because it reflects when the sale actually occurred, not when the cash was received. Looking back at our example, the accrual method may show an increase in sales in February, letting the owners know that their President’s Day sale was a success. If the sales were recorded when cash was received, it would be dependent upon when people paid. Some people may pay in March, others in April, and some in May. This does not accurately reflect what happened or why. Which can cause problems for the company as they try to make future business decisions.
Overall, the accrual method gives a more accurate and descriptive financial picture of a company’s income and expenses, therefore being more financially accurate than the cash accounting system. This increased accuracy can lead to better loan rates for a business and can make a company more enticing to investors. The accrual method of accounting is required by the IRS for large companies, and usually for companies that carry inventory or that accept credit.
The primary disadvantage of the Accrual method of accounting is it’s complexity. It uses a matching system that says that for every revenue received there is a matching expense and vice versa. The increased complexity of this accounting method makes it more expensive to maintain.
With a better understanding of the Accrual Method, the disadvantages of the cash method becomes more obvious. For instance, the cash method has difficulty showing an accurate representation of a company’s finances. Let’s say a small contractor uses the cash method of accounting. He picks up a big job in November, and pays cash throughout November and December for payroll, material, and other expenses. Once completed, he invoices his client who pays for the work in February. The company now has excess expenses for the last two months of one fiscal year, and then a large influx the beginning of the next fiscal year. This can lead to high expenses for one year of taxes, and excess income the next, possibly resulting in paying higher taxes. This is not an accurate representation of how the business is actually performing. These types of misleading numbers can make it more difficult in obtaining financing.
If your business has used Cash accounting, and you have wondered about making a change to the Accrual method, hopefully this has helped you have gained a bit better understanding to make a more informed decision, or at least give you some basic knowledge when you talk to your financial advisor.