Accounting may cause a lot of headaches and become a source of stress, especially for business owners wanting to set up their books for the first time. With great business comes great accounting, which means the larger the business, the more challenging it is to manage its finances.
One of the fundamental decisions you must make in setting up your finances is deciding which type of accounting to use—cash basis or accrual basis. This article aims to explain the difference between these two and help you choose the best fit for your business needs.
How revenue and expenses are recognized and recorded spells out the main difference between cash and accrual accounting. Let’s take a closer look, shall we?
Cash Basis Accounting
Although cash basis accounting is relatively easy and simple to use, it also has its disadvantages and may not be appropriate for some businesses.
This type of accounting recognizes revenue only as soon as you’ve received the payment and not upon earning it. Meanwhile, it recognizes expense only once it’s been paid and not when it was incurred or billed by your supplier.
Basically, you get to easily track your cash flow with actual amounts that go in and out of your bank account. However, note that this alone does not provide an accurate picture of whether your business is doing well or not.
Accrual Basis Accounting
Accrual basis accounting, on the other hand, is more complicated than the former but offers more accurate and reliable information to aid you with your financial decisions.
Here, revenue is recognized the moment it is earned, regardless of whether or not the payment is already received; whereas, expense is recognized once it is incurred, following the same condition.
This follows the matching principle, an important concept in accrual accounting, wherein expense is recognized and recorded in the same period when the revenue is earned.
Now that you have the basic concepts of cash and accrual accounting, let’s understand these concepts better with the help of some examples.
The company made a credit sale on August 29 and sent an invoice to its customer on the same day, stating that the payment is due after 30 days. Although the payment is still due on September 29, the customer has already paid the amount due on September 25. In the company’s books, when will the revenue be recognized using cash basis accounting and accrual basis accounting?
In cash basis accounting, you will only recognize the revenue from the above sale on September 25—when you’ve received the payment from the customer and neither on the date you sent the sales invoice (i.e., August 29) nor on the payment’s due date (i.e., September 29).
However, in accrual basis accounting, you will already recognize the revenue on August 29 because this is when you have made the sale, although not necessarily the payment.
The company is billed by its lessor for its rent on March 23. The company only made its payment on April 30, when the payment was due. When will the company need to recognize the rent expense following cash basis accounting and accrual basis accounting?
In cash basis accounting, the company will need to record its rent expense on April 30—when the actual payment was made to the lessor.
For accrual basis accounting, the company will already have to record the rent expense on March 23—when the lessor billed the company. During this date, the expense is already considered as incurred regardless of its payment status.
In December, the company purchased its inventory of pajamas for $300 and sold them for a total amount of $700. How much is the related cost of goods sold during the same month when the sales were only $420 and 60% of the total inventory was sold? Note that the company uses accrual basis accounting.
In this example, following the matching principle under accrual basis accounting, the company should only record $180 [$300 x 60%] as the cost of goods sold to match the amount of sales of $420. Gross profit will be $240.
The company should not record the whole purchase amount of $300 as its cost of goods sold during the month. Accrual basis accounting will only allow you to expense those related to your current sales.
Assuming that the company both paid for the purchase of inventory and received payment for its sales in the month of December, the company will record its revenue for $420 but will also record the whole amount of $300 under cash basis accounting. This will generate a gross profit of $120 in the company’s books.
Moreover, let’s assume that in the next month (i.e., January), the company sold the remaining inventory (40% of total inventory) for $280. The same matching principle applies to accrual basis accounting; hence, the cost of goods sold will still be recognized based on the amount of sales. For sales amounting to $280, the corresponding cost of goods sold is $120 (40% of $300), yielding a gross profit of $160.
In cash basis accounting, the company will show a greater gross profit of $280 for the month of January since no additional purchases were made during this month. However, it does not mean that the company did better and is more profitable in January compared to December.
Refer to the table below to compare the gross profit between the two types of accounting for Example 3.
|Account||Cash Basis||Accrual Basis||Cash Basis||Accrual Basis|
|Cost of Goods Sold||$300||$180||-||$120|
This shows one of the disadvantages of cash basis accounting, wherein the amounts fluctuate depending on the cash inflow and outflow. These fluctuations may interfere with more consistent data, making it unideal for long-term analyses, such as profitability trends.
Ultimately, deciding which type of accounting to use for your business depends on your needs. Some may only need to track their actual cash flow; hence, cash basis accounting may be a better fit. Otherwise, if you need more detailed information about your numbers and performance, you’re better off with accrual basis accounting.