November 19, 2021
A well-designed accounting is essential for your business to maintain cash flow, and thus, deciding on the type of accounting system should be given priority in the first place. It may be hard for you to make the correct decision as a newcomer to this world. This discusses accrual accounting vs. cash accounting in a detailed manner, from which you can understand which system will meet your business needs.
Accrual Accounting vs. Cash Accounting
The two common types of accounting used by businesses to track finances and taxation are accrual and cash-based accounting. Both types have advantages and disadvantages. Depending on business factors like size and inventory, you have to choose a specific method. While accrual accounting recognizes costs and revenues when they are incurred, cash accounting recognizes these flows when the cash either leaves or enters the business owner’s bank account.
- Accrual-basis accounting is primarily common among large-scale businesses. Even businesses with average revenue of more than $26 million use this accounting method.
The method of accrual-basis accounting involves many complications and sometimes is much labour-expensive. As large businesses have to keep track of more transactions than small businesses and can afford higher expenses, they use accrual accounting.
- In the case of accrual-basis accounting, revenue is recognized when the business earns it. Usually, revenue is recorded before any change in the money occurs. Revenue is recorded when a customer receives a service or product, with the business expecting to receive the money in the future. Despite there is no cash involved in various costs of services and goods, those costs are recorded.
- Let us give an example. Suppose a person or an entity owes your business some amount of money. In that case, when you send an invoice to your customer, you will have to record the amount owed by the customer as revenue, even if that entity hasn’t made the payment.
- Accrual accounting provides a more realistic view of the financial situation of a business over the long term. That is why it is more beneficial for companies that have large amounts of inventory. However, the accrual accounting method also has its shortcomings. It does not actively track the business’s cash flow, which can be highly dangerous for companies facing a shortage in cash in the short term. Also, because they appear to earn profits for a long time, they eventually start spending money they do not have in their accounts. This situation may result in zero cash in the bank account. So, while having the accrual accounting method, you must keep someone who will track the outgoing expenses and incoming revenue to understand the actual cash situation of the company.
- When you use the accrual accounting method for your payroll, payroll taxes can be recorded as expenses as they are accrued, regardless of when the employees are paid. So, the net income that you record as your business income reflects that you will need to pay your payroll taxes even if they are not due. So, by an accrual accounting method, rather than spending the amount you owe, you can keep track of it.
- Small businesses mainly use Cash-basis accounting because they have to keep track of their cash flow at all times.
- There is less to keep track of in this method, and because of this simplicity, most small businesses prefer cash-based accounting.
- On the other hand, in cash-basis accounting, all revenue is recognized when it is received. All costs are also recorded when the money is spent. It means that whenever you check your bank balance, you can know what resources are exactly at your disposal. Thus, your revenue will not be subject to tax until your cash is in the bank account. However, there is a concept of ‘constructive receipt‘ for specific available amounts related to demand.
- Though the method is simple and the system is more manageable, cash-based accounting does not always give a clear picture of the actual financial situation of the business.
- Here we give an example. A company appears to be rich in cash but has large amounts of payable accounts, which are not yet paid. In that case, the financial situation reflected in the bank accounts may look good, which may not be appropriate. The reason is that investors may think the company is going to grow and make a profit, but in reality, it is losing money due to the uncleared payments.
- In contrast, cash-basis accounting helps the business actively track the cash flow.
On the other hand, if you use cash-basis accounting for your payroll, the payroll taxes you owe will not be counted as costs that offset your revenue until they are paid. So, the net income you report when filing the income tax return may be inflated in the short term. Thus, when you pay payroll taxes, they will be counted as costs, which, in turn, will lower your reported profit and tax liability.
When it comes to figuring out the net profit from tracking the expenses, different results are found for two different accounting methods. It will entirely depend on when you’re making the payments and also when you are receiving them. For example, when you calculate the net monthly profit for a cash-basis accounting, you will need to consider the payments received from an invoice sent to you the month before. On the other hand, if you use the accrual method, you will need to record the payments received and invoices sent in the current month.
From the above discussion of accrual vs. cash basis accounting, you can clearly understand that both methods have their strengths and weaknesses. The profit will completely depend on when you receive or give away the payments. To monitor all the transactions, you will indeed need a professional bookkeeper. For references, suggestions, and help, contact Accountant Perth anytime.