Differences Between Cash Accounting and Accrual Accounting
- January 22, 2020
- Posted by: admin
- Category: Business plans, Finance & accounting
To account your business books, you need to follow the principle as defined by the accounting methods. There are two primary accounting methods – Cash accounting and Accrual accounting that a business a choose and apply. Each method has its own way of accounting and impacts differently on how the business financials are measured.
A method that is right for one type of business, may not be accurate for others. It is important for businesses to know the difference between cash basis accounting and accrual basis of accounting, understand the impact and choose the one that suits your business.
Before we get into the key factors that differentiates cash accounting and accrual accounting, let us understand the fundamentals with examples.
Under the cash accounting method, transactions are recorded only when money changes hands. For example, On 1st June,2020, Max fashions sold garments worth Rs. 1,00,000/-. 40% on cash and remaining on a credit basis. Max fashions maintain accounts using the cash method.
On following the cash-based accounting method, Max fashions would recognize revenue to the extent of Rs. 40,000/- (i.e., 1,00,000*40%) on 1st June. Remaining would be recognised as an when it is received.
Under the accrual-based method of accounting, gross income/expenses are reported when it is earned/occurred, regardless of when the income/expenses are collected/paid.
If the above example is maintained in the accrual accounting method, 1,00,000 will be recognized as revenue on the date of sale. The credit sale of 60,000 will be recognized as accounts receivables and 40,000 as cash.
With this understanding let us discuss the difference between cash and accrual basis accounting.
Difference between cash accounting and accrual accounting
We have listed the key differences of cash accounting and accrual accounting that will help you decide on the accounting method.
| Cash Accounting Vs Accrual Accounting | ||
| Key factors | Cash accounting | Accrual accounting |
| Time of recognising revenue and expenses | Revenues are recognized when they are received, while expenses are recognized when paid for | The revenue/expenses will be accounted for when it is earned/occurred, regardless of when the income/expense is collected/paid |
| Usage of the accounting system | Cash accounting method applies the single-entry accounting system to manage the books. In which, the one aspect of cash, either going out or coming in is recorded | Double entry accounting system is followed by business who chose the accrual basis of accounting. Here, two aspects for every transaction is recorded in the books i.e. a receiving aspect and giving aspect in the form Dr and Cr |
| Impact on tax accounting and reporting | Cash basis accounting method is not suitable for managing and reporting the tax, especially the indirect tax. Because you will account the tax only when the invoice is paid instead of the date on which sale is made. Usually, the tax liability needs to be accounted on sales date | The most suitable method for accounting tax is the accrual method. Since all the transactions are accounted on the date they are made, the tax aspect too will be accounted, irrespective of whether the invoice is paid or not. Thus, the tax liability will be recorded and reported accurately |
| Impact on accounts receivable and payables | A big no to cash accounting method If you are a business who sells most on credit. Fundamentally, it records only when cash is exchanged, details of receivables and payables will not be recorded | Since the accrual basis of accounting follows the double entry system, the suppliers account for payables and customers account for receivables are accounted when transactions are made on credit. Thus, clear and accurate details of accounts receivables and payables are managed |
| Business suitability | This is suitable for a micro-sized business who deal mostly on a cash basis with less or no credit transactions | For small to large businesses, it is wise to opt for the accrual method of accounting as it provides accurate details including the accounts receivables and payables |
| Ease of accounting | Cash accounting is a simpler method that records only one aspect i.e. payments or receipts | The accrual method is little is complex as it involves recording all aspects of every transaction done in the business |
| Holistic view of business | Cash accounting does not take every transaction into accounting. As a result, the financials reports cannot be complete | By recording all the transaction into the accounting reports, the financial reports prepared using the accrual method are accurate and complete |
| Usefulness | Business can quickly know the liquidity and how much cash the business has generated | The accrual method of accounting is holistic, and one can get to know the details of P&L and true financial position of the business |
There is no right or wrong in choosing a cash or accrual method. Each method works differently and has its own advantages or disadvantages. Businesses need to consider their transactions, operations and choose the one that fits the best.
If you are a micro-business doing most of the transactions on cash with less or no credit, the cash accounting will be easy and simpler one to follow. On the other side, if you have a good number of transactions on credit, both buying and selling, the accrual method will be beneficial.
Once you understand the fundamental difference between cash accounting and accrual accounts, it becomes a lot easier to make the right choice. Another important factor to consider here is the flexibility of accounting software. No matter which accounting method you choose, the accounting software that you use should be flexible enough to support the method you have opted.