The Difference Between Cash and Accrual Accounting

In this article, we’re going to be taking a look at the difference between cash and accrual accounting. We’ll cover the pros and cons of the two methods, and by the end of this article, you should have a clearer view of whether cash or accrual accounting best suits your needs.

The main difference between accrual and cash basis accounting lies in the timing of when revenue and expenses are recognized.

With cash basis accounting a more immediate recognition of revenue and expenses is recorded and income is recognised only when money changes hands. So, for example, if you follow the cash accounting method and invoice a client for $500 in February 2019 but they don't pay you until June 2019, the revenue is recorded under June, not February.

With accrual basis accounting the focus is on anticipated revenue and expenses. So income is recognised as soon as they raise an invoice for a customer. And when a bill comes in, it’s recognised as an expense even if payment won’t be made straight away. So, for example, if you send an invoice for $200 on May 2019 but receive the money in October 2019, you make a record of that $200 accounts receivable in May 2019.

HERE IS A CLOSER LOOK AT THE PROS AND CONS OF CASH VS ACCRUAL ACCOUNTING:

ADVANTAGES OF CASH ACCOUNTING:

• It's a simple system that keeps track of your business cash flow and there is no need to keep track of things like accounts receivables and accounts payables;
• Shows how much money you have on hand;
• Suits smaller businesses if you mostly have cash transactions (for example, a hairdresser or grocery store);
• It’s an easier option for calculating GST, though not all businesses are allowed to use it
• income tax expense is easier to manage as you only have to pay taxes on revenue received within a particular month.

DISADVANTAGES OF CASH ACCOUNTING:

• It’s not accurate as it could show you as profitable when you haven’t paid your bills. The reason is that you don't have the complete picture of your financial status with out a record of accounts payable and receivables;
• It's not useful when making long-term financial decisions as you only have a day-to-day view of finances without a clear understanding of your debts/profits;
• It doesn't show money that is owed to you or money you owe to others

ADVANTAGES OF ACCRUAL ACCOUNTING:

• Suits businesses that don't get paid straight away (for example, architects who provide a service then invoice for it later);
• Tracks your true financial position by showing money owed to you and money you owe others;
• Is helpful if you deal with lots of contracts or large amounts of money;
• It provides a more realistic, long-term picture of your finances. With a more detailed report of your cash flow, the accrual method enables you to make more accurate projections for your revenue stream and put contingencies in place for dry spells;
• There is no need to change accounting methods when your business grows;
• Complies with GAAP (Generally Accepted Accounting Principles)

DISADVANTAGES OF ACCRUAL ACCOUNTING:

• Is more complicated than cash accounting so an in-depth understanding of bookkeeping methods is needed;
• It's time-consuming work. If you're the head of your company and you're handling bookkeeping too, keeping up with accounting accrual might prove to be too much work;
• The accrual method can give you a false sense of financial security. Because you're recording invoices that haven't been paid yet, you can trick yourself into believing there is already money in the bank;
• It puts you at risk of paying taxes for income before cash is received. If a customer or client hasn't paid before you must file taxes, you may end up having to shoulder the cost of income tax

WHICH ACCOUNTING METHOD IS BEST FOR YOU?

For freelancers and small business owners, whether to choose the cash vs. accrual method of accounting comes down to considering the pros and cons. Both have their own merits and demerits. Cash accounting can help you save tax but is not useful for financial strategies. It is also an easy and familiar bookkeeping method for keeping track of your monthly income and expenses. On the other hand, it doesn't give you the full view of your finances whereas accrual accounting presents an accurate picture of your company profits but can be complicated to manage.  Some critics might complain that accrual accounting involves a lot of tedious work. But with our modern-day accounting software, a major portion of these redundant tasks can be automated, thus increasing the efficiency of your accounting team. And if you want your business to grow in the next few years, it would be a smart move to learn the accrual method.