cash vs accrual accounting

cash vs accrual accounting

Cash vs Accrual Accounting

1. Introduction

When a business uses cash basis accounting, the income and expenses are recorded when received or paid. According to the IRS, it is the most commonly used method, which is probably because it is also the simplest. You defer income so it is not taxed until the next tax year and, “it is less complex than the pure accrual method, as it does not recognize accounts receivable or accounts payable accounts.” When the use of the cash basis accounting method creates negative perceptions, it is usually because this method does not match income and expenses to the period in which they occur. When you issue an invoice using cash basis, you must report the amount as taxable income, even though no payments have yet been received.

The way you report your revenue and expenses on your income statement can have an impact on your business. Small business owners have the option of using the cash basis accounting method, which in some cases can create a perception of lower income. This perception can be problematic in a number of applications, including attracting investors, getting a loan, and bidding on a contract. The alternative to cash basis accounting is the accrual method.

2. Advantages of Cash Accounting

For largest businesses, profit-and-loss accounting is the main point. So, these limitations of the cash method are severe – so severe that the Internal Revenue Service (IRS) specifically prohibits many large businesses from using the cash method. It is also banned by generally accepted accounting principles (GAAP). However, they may feel that because they don’t care much about marginal changes from one financial period to another, GAAP’s more sophisticated methods don’t provide as much value as the lower costs that could be achieved by using the cash method. Small businesses may feel even more strongly.

The cash method of accounting has the merit that it’s simple and inexpensive. It can even provide an accurate answer to the fundamental financial question – what was the yearly income? However, it does a poor job of tracking current asset or current liability balances, and it does not match transactions with the fiscal period in which they occurred. So, it generally does not provide a useful answer to questions about profitability.

The US generally accepted accounting principles (GAAP) give businesses a large amount of flexibility in choosing whether to use cash or accrual accounting. In particular, small businesses are allowed to use cash accounting even though it doesn’t provide a useful answer to the question the IRS cares about – what are the profits. This is because it allows them to minimize paperwork when filing their annual tax returns.

The accrual method of accounting recognizes liabilities, costs, revenue, and assets at the time of the transaction, regardless of when cash changes hands. That is, transactions that give rise to revenue are recognized when the revenue is earned, not when cash is received, and likewise for costs. The alternative, cash accounting, recognizes transactions only when cash changes hands. Revenue is recognized only when cash is received, and costs only when they’re paid. Cash accounting is simpler and costs less than accrual accounting. The main reason to use accrual accounting is to improve the accuracy of financial analysis.

3. Advantages of Accrual Accounting

The realization and the matching concept are necessary to measure the profit, and the concept behind this is the qualitative characteristic of the general purpose financial reporting, true and fair view. The quantitative historical cost measurement criteria are simple to apply for this concept. The role of future conditions, consequences, and its measurability is important to discern between profits and revenues. So, the theoretical framework is supported by the accrual accounting through the norms and the principles of IFRS (IAS). The primary framework of reference of international regulation is the framework, which describes the purpose of the financial statement, qualitative facilitative characteristics of the financial statement, definition of the elements of the financial statements, realization and matching concept, qualitative characteristics of the financial statement, and recognition criteria.

One important benefit of the accrual method is that it recognizes all profits and losses at the time when the transaction is completed. Therefore, the transaction is recorded regardless of when the cash deal takes place. This measurement criteria of the accrual accounting gives a true and fair view of the profit or loss of a business entity. The uniform revenue and expenses recognition in every accounting period implies realization and matching concepts. Under this method, profit is realized through the financially quantified changes in the ownership interest. The issuance of resources can create such ownership interest. This framework can be applied to every possession. It is necessary to stress the word “financially quantified changes in the ownership” because the realization and the matching concept measures the economic reality of the business.

4. Disadvantages of Cash Accounting

Under a cash system, assets are often understated on the balance sheet when companies have a high volume of transactions because many of the transactions are not included. For instance, accounts receivable, inventory, and fixed assets are often greater than reflected on the balance sheet under a cash accounting system because the company already planned to pay for the items at the end of the period. Since a cash system only reflects actual cash transactions, the company’s accounts receivable will be at a lower amount than if the company used an accrual system. Analysts are advised to see accounts receivable increases as reasons to worry, as they do not reflect a company’s inability to collect receivables in a timely manner.

One of the disadvantages of cash accounting is that it is hard to track, report, and plan expense obligations when they are incurred, unless using another accounting system than the cash accounting system. For example, when a company purchases office supplies at the end of one month, but payment is not required for another 30 days, a cash accounting system does not show that the company has deferred an expense obligation until the following month. This creates problems for management and financial reporting because they may inaccurately reflect financial performance. It is not a problem, however, when it is not considered material or when an accounting system that tracks and reports expenses when they are incurred is used.

5. Disadvantages of Accrual Accounting

An additional disadvantage of accrual accounting is that businesses are reporting income that they have not actually received. Accomplishing this involves accounts receivable and a journal entry. The same applies to revenue that the business has not necessarily earned. When a business fails to bill for a service that has been performed, it is showing income it hasn’t recognized. The method raises a number of serious questions for business owners such as: How does the business protect itself against dishonest employees or unexpected errors in the books? The primary possible disadvantage of the accrual method is that the government uses more revenue recognition rules. For example, the IRS has revenue recognition rules for long-term construction contracts, tax shelters, and the installment sale of property. Consequently, a business may desire to use the cash method if they have flexibility in the timing of the recognition of revenues and expenses. When electing the cash method, a business reports income in the year it is actually collected and expenses in the year they are actually paid. Under this method, a business will likely pay more tax in the future.

However, there are several possible disadvantages involved. One of the significant disadvantages of accrual accounting is the fact that it can be difficult for businesses to see their immediate financial situation. Most businesses use some sort of accounting software to calculate their accrual income. This software typically takes some time to record revenues and expenses, so the business doesn’t see their current financial situation. Another possible disadvantage is that the accrual method can overstate or understate a business’s financial condition. For example, a business can show more income than it actually collected. Similarly, a business can assume they have more money to pay their bills than they actually have. While these overstatements/understatements can result in big problems for a business, they generally don’t affect a business with experienced financial staff. However, a business that is new to the accrual method would be wise to establish tight financial controls so that an overstatement/understatement of income does not occur. Accrual accounting generally involves more time and effort than the cash method. There are more journal entries and more reporting requirements as a result. This means the method increases the risk of inaccuracy due to errors in the double-entry accounting methodology and potential misstatements by the preparer.