In accounting, there are two methods to record transactions -Cash basis and Accrual basis.
The difference between these two specifically lies in the timing of when sales and purchases are recognized in the books. While cash accounting recognizes revenue and expenses immediately, accrual accounting is based on the anticipation of revenues and expenses.
To simplify this, cash accounting is when you send or receive money via exchange of hands; whereas when you get a bill or generate an invoice, it is accrual accounting.
Cash accounting
Cash basis accounting recognizes income and expenses only when cash is exchanged. They do not count bills as expenses and invoices as income until fully settled. Cash accounting, despite its name, does not mean only cash as a form of payment; you can be paid electronically and still do cash accounting. It primarily involves money being credited and debited from your bank account.
It follows a single entry system that records the inflow and outflow of cash.
This method is used by small businesses or for personal finances.
Benefits
• Simple as it shows how much money you have in hand
• Easy track of cash flow
• Immediate recording keeping
• You only have to pay tax for the cash you have received and not for the invoices issued. However, not all companies are allowed to use cash basis accounting for tax. Have trouble with accounting? Hire accountants from India and save up to 70% on your expense.
Drawbacks
• Inaccurate as it can show profits even when you haven’t paid your bills
• Financial statements cannot be audited
• Difficult to make management decisions as it only has a day-to-day view of the finances incurred
Accrual accounting
Accrual accounting records income as soon as an invoice is generated for a customer and when a bill comes in, it’s recorded as an expense even if the payment is not made. It is done with the expectation that payment will be made in the future.
It follows a double-entry system where each transaction has two outcomes in the form of credit or debit.
Accrual accounting is very complex in nature and requires great assistance. Hire accountants from India and save up to 70% on your expense.
This method is used by large corporations and publicly traded companies.
Benefits
• Accurate
• Financial statements can be audited
• Better management and record-keeping of finances
• Better financial decisions
• Better for long-term goals
Drawbacks
• Manage invoices and bills, not just your bank account
• Pay tax before the customer pays you
Example: Cash accounting and accrual accounting
Let us say that you own a car repair shop. Now when you provide services say worth $3,000 to the customer under the cash basis, the revenue is not recorded until and unless the customer has paid you the amount of $3,000. Under the accrual method, as soon as you have delivered the service and generated an invoice for the same, it is recorded as revenue even though your customer has not paid you.
The same goes for the expenses. If you receive an electricity bill of says $ 1,500under in the cash method, you will have to pay $1,500, or else the expense will not be recorded in the book. Whereas under the accrual method, the expense is recorded on the day you have received the bill.
Which is better: cash accounting or accrual accounting?
Both cash and accrual accounting have their own advantages and disadvantages and neither of them shows a complete frame of the company’s financial health.
However, the accrual method is widely used by companies as it levels out the earnings over time and maintains a record of all revenues and expenses generated in a business throughout while revenues and expenses generated in the cash method are considered irregular.