Cash basis Vs Accrual Basis Accounting
Two of the most common accounting methods used by businesses are Cash Basis and Accrual Basis accounting. While they may seem similar, these methods have distinct differences that can significantly impact your financial reporting, tax obligations, and even cash flow management. The primary difference lies in the timing of when sales and purchases are recorded.
Cash Basis Accounting
Cash basis accounting recognizes revenues and expenses only when money actually changes hands. This method does not take into account accounts receivable or accounts payable.
Key Features of Cash Basis Accounting:
Revenue Recognition: Revenues are recorded when cash is received.
Expense Recognition: Expenses are recorded when they are paid.
Simplicity: This method is straightforward, making it easy to determine when a transaction has occurred because it’s based on actual cash flow.
Cash Flow Tracking: Businesses can easily track how much cash they have at any given time by simply looking at their bank balance.
Taxation: Income is not taxed until it is received, which can be beneficial for managing cash flow.
Example: Imagine you receive $1,000 from a client for a project completed last month. Under cash basis accounting, this revenue is recorded when the payment is received, not when the project was completed.
Accrual Basis Accounting
Accrual basis accounting, on the other hand, records revenues and expenses when they are earned or incurred, regardless of when the cash is actually received or paid.
Key Features of Accrual Basis Accounting:
Revenue Recognition: Revenues are recorded when they are earned (e.g., when a project is completed).
Expense Recognition: Expenses are recorded when they are billed (e.g., when an invoice is received).
Realistic Financial Picture: This method provides a more accurate picture of a business’s financial status over time, showing the true profitability during a given period.
Cash Flow Awareness: While it offers a more realistic view of financial performance, it doesn’t provide immediate awareness of cash flow. Businesses can appear profitable on paper but may have empty bank accounts.
Example: Suppose you send out an invoice for $5,000 for a web design project completed this month. Under accrual basis accounting, this revenue is recorded when the project is completed, not when the payment is received.
Comparing Cash Basis and Accrual Basis Accounting
Revenue Recognition:
Cash Basis: When cash is received.
Accrual Basis: When it’s earned.
Expense Recognition:
Cash Basis: When cash is spent.
Accrual Basis: When they’re billed.
Taxation:
Cash Basis: Taxes are not paid on money that hasn’t been received yet.
Accrual Basis: Taxes are paid on money that you’re still owed.
Usage:
Cash Basis: Commonly used by small businesses and sole proprietors with no inventory.
Accrual Basis: Required for businesses with revenue over $25 million.
The Effects of Cash and Accrual Accounting
To illustrate how these accounting methods impact financial statements differently, consider the following transactions in a month:
Sent out an invoice for $5,000 for a web design project completed this month.
Received a bill for $1,000 in developer fees for work done this month.
Paid $75 in fees for a bill received last month.
Received $1,000 from a client for a project invoiced last month.
Cash Flow Impact:
Cash Basis Profit: $925 ($1,000 in income minus $75 in fees).
Accrual Basis Profit: $4,000 ($5,000 in income minus $1,000 in developer fees).
This example highlights how the choice of accounting method can affect the appearance of income and cash flow. Cash basis accounting shows a lower profit due to the immediate recognition of cash transactions, while accrual basis accounting shows a higher profit by recognizing revenue and expenses when they are incurred.
Last updated
Was this helpful?