You might have learned the terms Cash-Basis and Accrual-Basis on various occasions and might be wondering what those terms mean and how the two accounting treatments affect businesses and decision-making. Below is the summary of the definitions, applications, and key pros and cons of both methods.
The most straightforward advantage of the cash-basis approach is its simplicity. In this treatment, the revenue is recognized when the cash is collected, and expenses are recognized when the cash is paid. Under the cash basis, there is no need to account for customer sales made on credit (i.e. accounts receivable) until they pay. Similarly, no bookkeeping is required for purchases from vendors on credit (i.e. accounts payable or accrued expenses) until the company pays for them. Cash-basis accounting is a simple way to easily see a company’s cash status. Many businesses prefer to use cash accounting because the financial statements closely reflect their cash position, which is especially important for small business owners. The simplicity also makes bookkeeping easier and cheaper. And under cash-basis accounting, a business doesn’t have to pay taxes on cash it hasn’t collected.
The main disadvantage of the Cash-Basis is that financial reports may not represent reality at a given point. For example, a business may make a sale in 2019 but expects to be paid for it only in 2020.
In this case, the revenue is recorded in 2020 when the transfer of the ownership of the assets occurred in 2019. This would distort the picture as in 2019 company would report no sales. Another disadvantage is that Cash accounting mostly follows a single-entry system while Accrual accounting follows a double-entry system. Another limitation is that under IRS rules Businesses with more than $25 million in gross revenues can not run the books on Cash-Basis, hence, the method is limited to small businesses.
The Accrual method is considered to better match revenues and expenses and standardizes reporting information for comparability purposes. Accrual accounting bookkeeping is uncoupled from when the money involved actually changes hands, thereby smoothing the impact of timing and yielding a more accurate overall picture of business’ operations. Rooted in the concept of the matching principle, where revenues and expenses are recognized in the period in which the transaction occurs and not when cash exchanges hands, accrual basis accounting provides more timely insights for analysts and investors.
However, accrual basis accounting relies on estimates and assumptions from management, providing management with the opportunity to manipulate the appearance of its financial performance. The accrual component of a company’s earnings is commonly less persistent over time. When making comparisons of companies, generally those with a higher proportion of accrual-based earnings are considered to have weaker earnings than those with a higher proportion of cash flow-based earnings. Another disadvantage of accrual accounting is the additional bookkeeping. Rather than just looking at cash coming in and out, businesses using accrual accounting monitor receivables, prepaid expenses, accounts payable, and other accrued liabilities. It also requires more frequent closing of the company’s books. Another disadvantage is that the accrual basis might obscure short-term cash flow issues in a company that looks profitable on paper.
The accrual basis of accounting is the gold standard because it gives a more accurate representation of a company’s finances. Cash-basis accounting might be right for your business if you rely on cash payments for revenue and expenses. Conversely, businesses that extend credit to customers or use credit with their suppliers tend to find that accrual accounting gives a better picture of overall financial health. Businesses that hold large amounts of inventory also benefit from accrual accounting. In general, the greater the lag in conversion to cash from sales, the stronger the argument for accrual-based accounting.