Cash Accounting vs Accrual Accounting
A business uses an accountant with sound accounting knowledge to prepare a company’s financial statements. These financial statements can be prepared by using either of the two methods; cash accounting or accrual accounting. Cash accounting and accrual accounting are distinguished from each other based on the types of businesses that use these accounting methods, levels of complexity in preparation, and the timing in which the transactions are recorded. The following article will help the reader clearly understand the differences between these two forms of accounting in relation to the factors earlier mentioned.
Cash accounting is a straightforward method of accounting in which transactions are recorded in a company’s accounting books, only when the cash has been exchanged in completion of the transaction. In that sense, for example, if a sole trader sells a pair of shoes to his customer on credit, the sale will not be recorded until the seller receives the cash. In the event that a sole trader agrees to make a payment for an amount he owes, this will not be recorded until the funds are received by the creditor. This form of accounting is more commonly used by smaller businesses that do not require professional accountants to prepare their statements.
Accrual accounting is used mostly by medium to large organisations and under this method transactions are recorded as and when they occur, regardless of whether the funds are exchanged to complete the transaction. This method of accounting is considered to be the standard for maintaining accounts for many companies, and offer a better insight into a firm’s financial situation at the time. The accrual accounting method is also more complicated and requires the services of a professional accountant, which can usually be quite costly for a company. For example, if a customer purchases a watch by using a credit card, company will not wait for the funds to be received to record the sale in their accounting records, as accounts receivable. The same applies to a payment that is promised; it is recorded as accounts payable.
What is the difference between Cash and Accrual Accounting?
Maintaining a proper record of accounting information is essential to any firm and this can be done by using either accrual accounting or cash accounting. However, these two methods are very different from each other, because accrual accounting will record the transactions as and when they occur, and cash accounting will record them only once the cash has been exchanged. Accrual accounting allows the revenues to be coupled with the expenses for the period, and this increases the accuracy of the accounting records.
However, in cash accounting a record of the transaction is made in the accounting books only when the cash has been exchanged between the two parties. For example, if a company makes many sales on credit amounting to $1000, this will not be recorded in the accounting statements under the cash accounting system, as cash is not received. Assuming, at the same period, if the firm pays its creditors, an amount of $600, under cash accounting this would have been recorded as a payment of $600. The overall accounts will show a loss of $600, because even though the $600 is entered the $1000 is not recorded as accounts receivable. On the other hand, under accruals method, $1000 would be entered as receivables and $600 would be recorded as a payment, so the company would have made a profit of $400. In this sense, cash accounting may give a distorted picture of the revenues and expenses for the period.
Cash accounting is straightforward and less expensive, whereas accrual accounting is complex and requires expensive services of a professional accountant.
In a nutshell:
Cash vs Accrual Accounting
• Cash accounting will only record transactions during the time that the cash is exchanged, and accrual accounting will record transactions once the transaction is made, regardless of whether payments are made or funds are received.
• Accrual accounting helps a firm to have a more accurate record of its transactions by allowing the revenues of the period match with the expenses for the period.
• Cash accounting is much simpler than accrual accounting and less expensive but may result in a distorted picture of the company’s financials.
• An accrual accounting system is recommended, as it is in accordance to the accruals concept of accounting, and accrual accounting is an accurate portrayal of the firm’s financial situation at the time.