The fundamental difference between cash basis accounting and accrual accounting is primarily about when expenses and revenue are introduced, with the cash method adopting a system where this income and expenditure is recognized immediately.
Although this can be seen as the most obvious difference between the two accounting methods there are more subtle variations and options that distinguish these two accounting practices.
Let’s take a look at the mechanics of both ways to account for sales and expenses and highlight some of those key differences.
Accounting for revenue when it is earned
Accrual accounting is about recording revenue that is being earned at the point of sale and without the need for cash to have changed hands at that point of the transaction.
For example, with accrual accounting, you would record a sale when you have delivered a product or service to one of your customers but have not yet been paid for that transaction.
Basically, you are recording expenses and revenue without cash being paid out or received at the point you raise an invoice.
Noting when cash is received
If you are using the cash accounting method you will be reporting revenue only at the point that you physically receive the money into your bank account.
At the same time, expenses are only recorded when you pay the cash out.
It is a more simplistic accounting method in comparison to accrual accounting and one that is favored by smaller businesses and sole traders who find it easier to manage their finances in this way.
Only seeing the immediate view
A significant disadvantage attached to the cash accounting method is that it can provide you with a misleading picture as to the true state of your finances.
Although cash accounting is beautifully simple and makes it easier to track your cash flow as a result, the drawback is that the financial health of the business can’t be measured alone by how much cash you have in the bank at any one time.
You could have a large amount of money owed by the business and those payable sums could exceed what you have in the bank, creating a misleading picture as to the financial health of the business.
The accrual method helps improve that scenario as you are recording everything you earn and owe as it is accrued, allowing you to see into the future of your business’s finances with greater ease.
Tracking cash flow
It is a balancing act between the pros and cons of either method and with the accrual method you should be aware that you won’t be tracking cash flow as easily as the cash method.
This will mean that you might find it harder to anticipate short-term cash flow problems despite seeing that the longer-term outlook looks profitable.
Both accounting methods have their own merits and if you have a greater understanding of how each one works you can use them to full advantage and enjoy greater control over the financial health of your business.