Business owners have two options when it comes to accounting methods: cash basis and accrual accounting. These approaches not only affect how records are kept, but also offer different insights into a company’s financial performance.
Cash basis accounting, as the name implies, provides a clear understanding of a company’s cash reserves and is relatively easy to comprehend. However, it may not provide a comprehensive view of a company’s financial health as it does not include incoming payments or commitments that are yet to be paid. For instance, upcoming lease payments or revenue from booked orders that have not yet shipped may not be reflected.
Cash basis accounting does not match expenses with related revenue, resulting in a distorted view of a company’s performance. The timing of income and expenses recorded is heavily dependent on when invoices are issued or bills are paid, leading to greater fluctuations in a company’s performance.
On the other hand, accrual accounting records revenue and expenses as they are earned or incurred, providing a smoother picture of a company’s financial situation. For instance, payroll expenses are recorded as employees work, rather than when their salaries are deposited.
Accrual accounting also offers a more comprehensive view of a company’s profitability by including revenue when products or services are delivered to customers, with the expectation of receiving payment. It even accounts for bad debts, in case of non-payment, which may occur rarely.
The Evolution of Accounting: From Ancient Records to Modern Practices
Accounting has been a part of business for as long as people have been conducting trade. In fact, evidence of accounting records dating back thousands of years has been found in Mesopotamia.
In the 15th century, Luca Pacioli, a mathematician and Franciscan friar, described a record-keeping system used by Venetian merchants. His work helped establish the basis for accrual accounting, which has evolved into what we know today.
As businesses grew and became more complex, so did the discipline of accounting. During the Industrial Revolution in the 18th and 19th centuries, accounting gained significance as more businesses sought external investment. To provide assurance to investors, the Institute of Chartered Accountants of Scotland was launched in 1854, becoming the world’s first professional body for accountants. Over time, similar professional bodies were established worldwide.
The Evolution of Accounting: From Ancient Records to Modern Practices
Accounting has been a part of business for as long as people have been conducting trade. In fact, evidence of accounting records dating back thousands of years has been found in Mesopotamia.
In the 15th century, Luca Pacioli, a mathematician and Franciscan friar, described a record-keeping system used by Venetian merchants. His work helped establish the basis for accrual accounting, which has evolved into what we know today.
As businesses grew and became more complex, so did the discipline of accounting. During the Industrial Revolution in the 18th and 19th centuries, accounting gained significance as more businesses sought external investment. To provide assurance to investors, the Institute of Chartered Accountants of Scotland was launched in 1854, becoming the world’s first professional body for accountants. Over time, similar professional bodies were established worldwide.
Milestones in Accounting: From Professional Bodies to Modern Solutions
In the world of accounting, professional bodies have been established around the globe to maintain standards and promote best practices. CPA Australia, which also covers New Zealand, was founded in 1886, followed by the Philippine Institute of Certified Public Accountants in 1929, the Institute of Chartered Accountants of India in 1949, the Institute of Singapore Chartered Accountants in 1963, and the Hong Kong Institute of Certified Public Accountants in 1973.
Despite these efforts, issues such as stock market manipulation and financial fraud still occur. To address these problems, regulatory bodies like the Australian Prudential Regulation Authority and the Monetary Authority of Singapore were established. The first-ever accounting standards, the USA’s GAAP, were developed in response to the 1929 stock market crash and the subsequent Great Depression.
While no accounting method can completely eliminate the risk of financial wrongdoing, companies that engage in fraudulent activities can face severe consequences. One well-known example is the Enron scandal, where the company overvalued its assets, leading to its bankruptcy and the conviction of over 20 employees.
In recent years, software solutions have emerged to streamline bookkeeping and accounting processes, giving business owners and accountants more tools to analyze transactions and maintain accurate records.
Cash Basis Accounting Explained
Under cash basis accounting, businesses recognize revenue when they receive payment, such as when a check clears and the funds are deposited into their account. Similarly, expenses are recorded when payment is issued.
This method of accounting can result in discrepancies between the timing of cash inflows and outflows and the actual delivery of goods or services or the incurrence of expenses.
Cash Basis Accounting: Who Can Benefit?
Cash basis accounting is popular among self-employed professionals and small-business owners due to its simplicity and ability to provide a clear picture of available funds, an important metric for any company.
Cash basis accounting is not suitable for all businesses. Companies that carry inventory or offer services on credit will typically require accrual accounting to track inventory changes and revenue recognition.
Illustrations of Cash Basis Accounting
Let’s say a house-painting business finishes a project in April and sends an invoice, but the homeowner pays with a credit card in May. If the business uses the cash basis accounting method, the income will be recorded in May when the payment is received, even though the job was completed several weeks earlier. This creates a time gap between when the “economic event” occurred and when it was recorded.
Now let’s consider that the same house painter receives an electric bill of $175 for services provided in April but pays it in May. Under the cash basis accounting method, the $175 will be recorded as a May expense, even though it relates to services provided in April.
Understanding Accrual Accounting: Recording Revenue and Expenses
Accrual accounting is a method of recording revenue and expenses when they are earned or incurred, regardless of whether or not money has been exchanged. This method involves using debit entries to increase expenses and reduce revenue, while credit entries have the opposite effect, decreasing expenses and increasing revenue. The sum of the debit and credit entries cancel each other out.
For instance, a house-painting company following accrual accounting would record a sale when the painting job is finished, even if no payment has been received. Similarly, a business owner would record an electric bill when it is incurred, regardless of whether or not it has been paid.
Comparing Cash Basis Accounting to Accrual Basis Accounting: Key Differences
Cash basis accounting is generally simpler and easier to manage, making it a good fit for small businesses or startups with straightforward financial transactions.
As businesses grow and become more complex, accrual accounting often becomes the preferred method. Accrual accounting records revenue and expenses when they are incurred, regardless of whether or not money has changed hands. This method also enables tracking of inventory, accounts receivable, and accounts payable, providing a more accurate view of the company’s financial position.
However, accrual accounting can be more time-consuming and challenging to comprehend than cash basis accounting. It may also be harder to determine the actual cash available to the business.
Cash vs Accrual Accounting: Which Is Right for Your Business?
Comparing Cash Basis Accounting to Accrual Basis Accounting: Key Differences
Cash basis accounting is generally simpler and easier to manage, making it a good fit for small businesses or startups with straightforward financial transactions.
As businesses grow and become more complex, accrual accounting often becomes the preferred method. Accrual accounting records revenue and expenses when they are incurred, regardless of whether or not money has changed hands. This method also enables tracking of inventory, accounts receivable, and accounts payable, providing a more accurate view of the company’s financial position.
However, accrual accounting can be more time-consuming and challenging to comprehend than cash basis accounting. It may also be harder to determine the actual cash available to the business.
Deciding Between Cash Basis and Accrual Accounting
Choosing an accounting method for a business does not require regulatory approval initially, but a change in methods does. Additionally, if a business uses the cash method for revenue, it must also use it for expenses.
Several other considerations can impact the decision between cash and accrual basis accounting:
A business using cash basis accounting does not record income until receiving payment, which can decrease its net income and taxes owed at year-end by accelerating some expenses.
Some lenders and investors may require accrual-based accounting from the start. If a business plans to seek outside funding within the next few years, starting with accrual accounting could be beneficial.
Similarly, some business buyers may require audited financial statements, which necessitate accrual accounting. If a business owner plans to sell their business within a few years, they should begin using accrual accounting if they haven’t already.
Ultimately, the most critical factor in selecting an accounting method is finding the one that best suits the business.
| Cash Basis | Accrual Basis | |
|---|---|---|
| Description | Under the cash basis accounting method, revenue is recognized when payment is received, and expenses are recorded when payment is made. | The accrual accounting method records revenue and expenses when a transaction is initiated, regardless of whether payment has been made or received. |
| Advantages | The cash basis accounting method is relatively straightforward and easy to comprehend. It provides an accurate representation of cash available at any given time. | The accrual accounting method provides a more precise matching of income and expenses to the periods in which they occur. It allows for inventory tracking and generally offers more comprehensive information for long-term planning purposes. |
| Disadvantages | Since the cash basis accounting method does not account for accounts receivable and payable, it does not immediately reflect money owed or bills that need to be paid. Additionally, it does not incorporate inventory tracking, partial payments, or uncollectible accounts. | The accrual accounting method is comparatively more complex and time-consuming to use. There is a chance that a business may owe taxes on income that it has not yet received under this method. |
| Which businesses generally use this method | Typically, smaller and newer businesses. | The accrual accounting method is generally preferred by larger and more complex businesses, including publicly traded companies. It may also be required by regulatory authorities, lenders, and investors in certain circumstances. |
Comparing Cash Basis and Accrual Accounting for Businesses
The cash basis accounting and accrual accounting methods have their own advantages and disadvantages that make them suitable for different types of businesses.
Benefits of Using Cash Basis Accounting for Small Businesses
Cash basis accounting is often favored by small business owners due to its simplicity. This method is easy to teach finance personnel and requires less bookkeeping compared to accrual accounting. Despite its simplicity, cash basis accounting provides adequate information for small businesses to track their performance. Furthermore, since it does not take future payments and revenue into account, it provides a clear view of the company’s current cash position.
Drawbacks of Cash Basis Accounting and the Advantages of Accrual Accounting
Cash basis accounting can present an incomplete picture of a business’s performance since it does not align expenses with the revenue they help generate. For instance, if a company buys $500 worth of T-shirts in August and sells them for $700 in September, cash basis accounting would indicate a loss of $500 in August and a profit of $700 in September. Neither figure truly represents the business’s performance.
In contrast, the accrual basis of accounting, which takes into account accounts receivable and payable, may more accurately reflect a company’s performance. This approach can provide a stronger foundation for long-term planning and is sometimes required by lenders who work with businesses.
The Benefits of Using Accounting Software for Cash Basis Accounting
Whether a business uses cash basis or accrual basis accounting, accounting software can assist in accurately implementing the chosen method. With the help of accounting software, accounting processes can be streamlined, and compliance with regulations can be ensured. NetSuite offers a range of accounting solutions that can help businesses achieve these benefits. To discover how NetSuite can help with accounting needs, arrange a free consultation today.
