Cash accounting and accrual accounting.
If you keep track of your record revenues and business expenses, we’re certain you’ve come across these terms before.
But, what exactly do they mean?
We’ll look deeper into the two methods and find out how they can affect your business financially.
Cash basis accounting vs. accrual basis accounting: What’s the difference?
Let’s start with the basics.
Cash basis accounting is a method used to record business income and expenses only when money is exchanged. This means bill expenses and invoices set as income are not accounted for until they are paid.
When documented, this method does not acknowledge accounts that will be received or paid at a later date.
On the other hand, accrual basis accounting recognizes all income and expenses when they are incurred. This means revenues and expenses are recorded when earned, whether the money has been paid for or not.
Now that we’ve covered each method’s differences, we’ll next share the advantages and disadvantages of both.
Advantages of cash basis accounting
- The cash basis method is easy to implement, maintain and understand.
- This method provides a clear cash flow of a business and helps individuals see the little difference between their financial statements and tax returns
Disadvantages of cash basis accounting
To every advantage, there is a disadvantage; here are some for the cash basis method:
- Although this method showcases financial statements as accurate, it is not. For example, a business owner’s account could look profitable because of the paid items recorded however their bills may not be paid.
- This method can come off as an illusion with a less realistic idea of income and expenses during a set time which doesn’t help when making management decisions.
Advantages of accrual basis accounting
- The accrual basis method gives a more realistic idea of income and expenses during a period of time, therefore providing a long-term picture of the business that the cash basis method can’t provide.
- This method conforms to the generally accepted accounting principles, or GAAP, where are standards that cover the financial legalities of various businesses and corporations.
Disadvantages of Accrual Accounting
- Although this method is very realistic, accrual basis accounting can be time-consuming and difficult if not managed well.
- Cash flow awareness is not provided when using this method. For example, information can be recorded for a business, but physically those funds may not be there.
Which method is best for your business?
At the end of the day, the choice is yours regarding what method is best for your business. Many small businesses start with the cash basis method because it is easy to maintain and manage, and it prepares you for the accrual method, which the IRS requires once your account reaches more the $25 million in gross receipts.
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