Accounting Methods: Cash and Accrual Accounting
Accounting for business involves rules and techniques used by the company to measure income and expenses. These accounting rules are what is termed as Accounting Methods. The two general methods used by businesses are the cash basis and accrual basis of accounting.
The principal difference between cash accounting and accrual accounting is on the timing of recognizing the revenue and expense accounts. Cash basis is more prompt on recognizing revenue and expense, while Accrual basis, on the other hand, is more on anticipated revenues and expenses.
It is important to understand accounting methods because their resulting information is beneficial for managers to assess and make decisions on the business’ financial standing.
Under the cash method of accounting, income is recognized in the books when received, and expenses are recognized when paid. Cash basis is more focused on the real-time flow of cash towards the company and outside the company, hence its name ‘cash’ accounting. The cash method is easier; thus, it is usually used by small entity businesses and for recording personal finances.
Under the accrual method of accounting, income is recognized when earned notwithstanding the time of when it was received. Expenses are also recognized when incurred, no matter when it was paid.
Income is accrued when the right to receive the money due is established, i.e. when the service is rendered or when the product is delivered to the customer. Expense is accrued when the right to pay the counterparty is established (e.g. purchase expense is recognized when purchased products are received, and rental expense for the month is established when the month has elapsed).
Accrual accounting focuses more on the substance of the economic transaction. The accrual method depicts a more accurate picture of the business’ financial situation by incorporating accounts payable and accounts receivable. This method is the most commonly used accounting method as it evens out earning over time. It is most especially used by publicly traded corporations.
Advantages and Disadvantages
The primary advantage of cash accounting is its simplicity- it only considers cash paid and cash received. This makes the tracking and analysis of cash flow easier. With this method, it is easier for decision-makers to understand how much cash the company has in the bank or on hand, at the moment or at a specific point in time.
The cash basis also provides a tax advantage. Because you report revenue and expense only when physical money is moved, you can legally control your tax liability by controlling the timing of transactions.
The disadvantage of the cash basis accounting, however, is that it provides a narrow view of your business. Cash basis does not report the business’ liabilities, therefore you may think that you have more free cash to spend than you truly have.
Another disadvantage of the cash method is that you cannot use the cash method if you sell goods or services at credit, as you have to keep track of the customers who do not pay right away.
On the other hand, accrual accounting is advantageous because it provides a more accurate perspective of the business. For example, the business might have sales that would not be recorded under a cash basis because the receipt of payment is not expected until the next quarter. This might give the investors the impression that the company is not doing well when in reality it is profitable.
Disadvantages of accrual accounting include complexity in the record-keeping of accounts like unearned revenue and prepaid expenses. Furthermore, accrual accounting does not provide ease in tracking cash flows that might not report cash shortages in the short-run.
Understanding accounting methods is helpful in deciding which methods to use in your business. Cash basis is the most convenient method often used by small businesses. Accrual accounting is complex but it provides a more accurate picture of the business.
Do you have questions or issues regarding your business finances? Consult your Philippines accounting specialists now. 3E Accounting is an international network of experienced professionals geared to providing efficient and effective financial services to its clients. Contact them today!