Cash vs Accrual Basis for Accounting

The differences between cash and accrual methods of accounting are great. There are good and bad points to both methods, and you should understand them before you start keeping the books.

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Before you start keeping the books for a business, there is one major accounting question you have to answer. Are you going to use cash or accrual basis of accounting? Almost all larger businesses use the accrual basis of accounting. However, it really depends on what type of business you are in. To make the decision, you should understand the differences in the two methods.

A cash basis of accounting is very straightforward. When you receive cash, you record it in the books. When you pay cash, you record it in the books. There is no recording of cash flow because of what is going to happen tomorrow. This method is simple and easy to understand, however, it may not accurately depict the financial standpoint of your business.

An accrual basis of accounting is a little more complicated. This method is always used in corporations. The rules come from GAAP, or generally accepted accounting principles. The recording of cash flows is based on what is going to happen, and not necessarily on what has already occurred. If you sell an item on credit, you record the money at the time of the sale. If you have agreed to pay someone else, you pay then. This is advantageous because the recognition of a sale is quicker. However, it is disadvantageous in that you may have an inaccurate cash flow on the books that you will have to correct. This may happen if a customer fails to pay. Also, it may happen if a supplier falls through on a deal, and you don’t pay.

In an accrual basis of accounting, things other than cash will impact the net income of your business. For example, if you buy merchandise that cost 100 dollars for resale in a cash basis of accounting, you will only record an outflow of 100 dollars cash. However, if you use an accrual basis of accounting, you will record an outflow of 100 dollars cash and an inflow of 100 dollars of merchandise for the same amount. In that way, the net change in income was zero. The net cash flow was -100 dollars in both situations. The accrual basis takes into account other things, including depreciation of long-term assets.

All in all, the accrual basis is usually the more accurate method. Some businesses are exceptions. One example is a company whose customers default on their payments often. Even in these companies, though, a semi-accrual basis is used. However, sometimes it is not cost or time efficient to use this method.