Small business owners are often confused about the difference between cash and accrual basis accounting. This might sound like something that an accountant should show but this information is useful for business owner as well. In this article, we’ve explained how each of these accounting methods work. Find out more which accounting method is best for your business.
Introduction to Cash method
Cash method is an accounting system that identifies income (or revenue) only when payment is accepted and expenses only when payment is done. The cash method is straight forward in sense that the business’s books are maintained on the basis of the real flow of cash in and out of the business. In this case, income is logged as soon as it is received, and expenses are reported when they are truly paid.
The cash method is implemented by several sole proprietors and trades with no inventory. The cash basis is generally practised by small companies and users because it is comparatively easier and less costly. Cash basis accounting does not follow with the rules of generally accepted accounting principles (GAAP) and it often leaves a time gap between recording the source of an action (purchase or sale) and its result (disbursement or receipt of money).
If in certain situation, a client pays you in advance, cash accounting method permits you to account for those funds on your income statement when they are accepted instead of waiting till you truly earn them. Cash method also offers a lot of inventive freedom to handle what you own in the bank to suit your own style of accounting and context at any time. This makes the accounting process easier for tracking internally.
Introduction to Accrual method
The accrual method of accounting is the theory of recording revenues when received and expenses as gained. Accrual method of accounting is the normal approach to recording and maintaining transactions for businesses. This method logs revenues on the income statement when they are received even if the client will pay after period of 30 days. In the situation when the revenues are earned the business will credit a revenue account and will also debit the asset account Accounts Receivable. In this case, when the customer pays after 30 days passed when the revenues were earned, the company will debit cash and will also credit Accounts Receivable.
The accrual method of accounting is supported under both generally accepted accounting principles (known as GAAP) as well as international financial reporting standards (known as IFRS). These accounting frameworks offer sufficient guidance on how to account for revenue and expense transactions in the devoid of the cash receipts or expenses that would activate the recordation of a business under the cash base of accounting.
In terms of accounting, the accrual method and the related adjusting entries will outcome in a complete and precise reporting of a company’s properties, equity, liabilities, and remunerations during all accounting process.
The profit of accrual accounting is perceived as more precise measure of a company’s productivity. Businesses are mandatory to apply the accrual basis when they comply with GAAP. The accrual method efforts to match the income received from a contract to the expenses incurred to that contract. Because of this, contractors repeatedly have to change their accrual methods through the lifespan of their business. This method applies chiefly to small contractors, though smaller entities may also apply methods such as the exempt percentage of completion method (known as EPCM) or completed contract method (known as CCM).
Example Of Cash Basis And Accrual Basis Accounting:
The difference between cash method and accrual method can be easily understood to you from few examples explained below:
For example, if you initiate an accounting service in month of December and offer INR 6 lacs of accounting services in December, but have not received any of the money from the customers till January, there will be an alteration in the income statements for December and January in the cash and accrual bases of accounting. Under the accrual method, your income statements will display INR 6 lacs of revenues in December and nothing of those services will be stated as revenues in January. Under the cash method, your income statement of December will display no revenues. In its place, the December services will be recounted as January revenues under the cash based method of accounting.
In above case, you will also find a difference on the balance sheet. In the accrual method, the balance sheet of December will report accounts receivable of INR 6 lacs and the assessed true profit will be supplemented to vendors equity or reserved earnings. In the cash method, the INR 6 lacs of accounts receivable will not be stated as an asset, in that case the true profit will not be encompassed in vendor’s equity or retained earnings.
There is another example of both these methods explained here. Your computer installation business completes a work in November, and doesn’t get remunerated till three months later in January. In the cash method, you would record the payment in month of January while in the accrual method you would record the revenue in your November books.
When to use Cash method in your business
Basically you need to use Cash method of accounting when cash actually changes hands. This means that it is used when cash payment is gained by the company from clients or paid out by the company for procurements or other services. You can use it when cash receipt or payment is to be made in the system of check, cash, credit card, electronic transfer, or other system used to pay for an item.
You can avoid using Cash-basis accounting if a store vends goods on store credit and bills the customer at a future date. There is no facility to record and track cash due from customers at a particular time in the future in this accounting method.
It is a pronounced option for personal businesses, independent contractors, and self-employed employees. The cash basis is only accessible for use if a business has no higher than INR 33 crore of sales for a year. It is simplest to accomplish transactions using the cash basis, as no complicated accounting transactions such as deferrals and accruals are compulsory.
When to use Accrual method in your business
The accrual method is used when it is required to be tax compliant. In such cases it is used when businesses that have additional of INR 33 crore in gross sales revenue.
The accrual method of accounting is more preferred when,
- A more comprehensive reporting of the company’s properties, liabilities, and stockholders’ equity at the termination of an accounting period is required,
- A more accurate reporting of a company’s incomes, expenditures, and net income for a precise time interval based on a monthly, quarterly or yearly basis is required.
This method is used when it is required to have tax reporting when sales surpass INR 33 crore. Also, a business’s financial statements can only be reviewed if they have been equipped using the accrual method. It is also used when the financial results of a business are more probable to match incomes and expenditures in the identical reporting period, in order that the accurate profitability of a business can be recognised.
Concluding Note
Cash method and accrual method are accounting methods that vary depending on the timing of when expenses and revenues are predictable. When a company implements cash method accounting, it identifies revenues when cash is essentially earned and expenses at the time they are paid. Using accrual accounting, income is predictable at the time revenue is gained (which may not occur when it is gained) and expenses are logged when liabilities are acquired (which may not occur when they are funded).
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