Accrual Accounting vs. Cash Basis Accounting: An Overview
The main difference between accrual and cash basis accounting lies in the timing of when revenue and expenses are recognized. The cash method providesan immediate recognition of revenue and expenses, while the accrual method focuses on anticipatedrevenue and expenses.
Key Takeaways
- Accrual accounting records revenue and expenses when transactions occur but before money is received or dispensed.
- Cash basis accounting records revenue and expenses when cash related to those transactions is actually received or dispensed.
- Accrual accounting provides a more accurate view of a company’s health by including accounts payable and accounts receivable.
- The accrual methodis the more commonly used method by large companies, especially by publicly traded companies, as it smooths out earnings over time.
- The cash basis method is generally used by sole proprietors and smaller businesses.
Accrual Accounting
Under accrual accounting, revenue is accounted forwhen it is earned. Unlike the cash method, the accrual method records revenue when a product or service is delivered to a customer with the expectation that money will be paid in the future.In other words, money is accounted for before it’s received. Likewise, expenses for goods and services are recordedbefore any cash is paid out for them.
Cash Basis Accounting
Under cash basis accounting, revenue is reported on the income statementonly when cashis received. Expensesare recorded only when cashis paid out. The cash method is typically used by small businesses and for personal finances.
Key Differences
Accrual Method
The accrual methodrecordsaccounts receivables and payables and, as a result, can provide a more accurate pictureof the profitability of a company,particularly in the long term.
For example, a company might havesales in the current quarter that wouldn’t be recorded under the cash method. The related revenue is expected in the following quarter. An investor might think the companyis unprofitable when, in reality, the company is doing well.
The accrual method doesn’t track cash flow. A company might lookprofitable in thelong term but actually have achallenging, major cashshortagein the short term.
Another disadvantage of theaccrual method is that it can be more complicated to use since it’snecessary toaccount for items like unearned revenueand prepaid expenses.It also may require added staff.
The accrual method is generally required for companies that file audited financial statements and is required under the generally accepted accounting principles (GAAP) issued by the Financial Accounting Standards Boards (FASB).
Cash Basis Method
The key advantage of the cash method is its simplicity—it only accounts for cash paid or received. Tracking the cash flow of a company is also easier.
It’s beneficial to sole proprietorships and small businesses because, most likely, it won’t require added staff (and related expenses) to use.
However, the cash basis method might overstate the health of a companythat iscash-rich. That’s because it doesn’t record accountspayablesthat might exceedthe cash on the booksand the company’scurrent revenue stream.
As a result, an investor might conclude that the companyis making a profit when, in reality, the company might be facing financial difficulties.
The cash basis method is not acceptable under GAAP.
Tax Law Change
The Tax Cuts and Jobs Act increased the number of small business taxpayers entitled to use the cash basis accounting method. For 2024, small business taxpayers with average annual gross receipts of $30 million or less in the prior three-year period can use it.
Special Considerations
The accrual methodis the more commonly used method, particularly by publicly traded companies. One reason forthe accrual method’s popularityis thatit smooths out earnings over time since it accounts for all revenues and expensesasthey’regenerated.
The cash basis method records these only when cash changes hands and can present more frequently changing views of profitability.
For example, under the cash basis method,retailers would look extremely profitable in Q4 asconsumers buy for the holiday season.However, they would look unprofitablein the next year’s Q1 asconsumer spending declines following the holiday rush.
Both methods have their advantages and disadvantages. Each provides different views of the financial health of a company. For investors, it’s important to understand the impact of both methods when making investment decisions.
The vast majority of companies that people would potentially invest in will be using accrual-based accounting. However, should you come across a small company using cash-based accounting, it’s definitely something to watch out for.
Accrual Accounting vs. Cash Basis Accounting: Example
Let’s say you own a business that sells machinery. If you sell $5,000 worth of machinery, under the cash method, that amount is not recorded in the books until the customer hands you the money or you receive the check.
Under the accrual method, the $5,000 is recorded as revenue as of the day the sale was made, though you may receive the money a few days, weeks, or even months later.
The same principle appliestoexpenses. If the company receivesan electric bill for $1,700, under the cash method, the amount is not recorded until the companyactually pays the bill. However, under the accrual method, the $1,700 is recorded as an expense the day the company receives the bill.
What Is Accrual Accounting?
Accrual accounting is an accounting method that records revenues and expenses before payments are received or issued. In other words, it records revenue when a sales transaction occurs. It records expenses when a transaction for the purchase of goods or services occurs.
What Is the Difference Between Cash Basis and Accrual Accounting?
Cash basis accounting records revenue and expenses when actual payments are received or disbursed. It doesn’t account for either when the transactions that create them occur. On the other hand, accrual accounting records revenue and expenses when those transactions occur and before any money is received or paid out.
Companies might also use modified accrual accounting and modified cash basis accounting.
When Does a Company Account for Revenue If It Uses Cash Basis Accounting?
Under the cash basis accounting method, a company accounts for revenue only when it receives payment for the products or services it provides a customer.
The Bottom Line
Accrual accounting and cash basis accounting are two ways to record financial transactions. They differ in when a transaction is recorded: accrual accounting when money is earned or an expense is incurred, and cash basis accounting when money is received or an expense is paid. Accrual accounting is required by law; however, there are exceptions where cash basis accounting can be used.
