There are two general methods of accounting: cash accounting or cash basis accounting and accrual accounting or accrual basis accounting. The cash basis method involves recording revenue when cash is received and recording expenses when they are paid.
On the other hand, in the accrual basis method, revenue is recorded only when it is actually earned from sales, and expenses are reported when they are incurred.
Understanding the difference between cash accounting and accrual accounting is essential to choosing which of these two methods suits a particular organization or situation. Of course, it is also essential to understand the advantages and disadvantages of each.
Advantages and Disadvantages of Cash Accounting
The following are the pros or advantages and applications of cash basis accounting:
• A major advantage of this accounting method is simplicity. It is simpler than the accrual method because it considers all cash received as income or revenues and all cash that moves out of the organization as expenses.
• Cash basis is generally the more popular method to report and record revenue. It is normally observed by freelancers and small businesses, to include sole proprietors or those organizations with small customer base and revenues.
• Another advantage of cash basis accounting is that it requires less effort in bookkeeping and generating financial reports. Essentially, this advantage translates to several benefits to include uncomplicated accounting activities and less expensive accounting costs.
• The method is generally applicable for individuals or entities that conduct business primarily using cash as opposed to credit.
The following are the cons and disadvantages of this accounting method:
• The simplicity of cash accounting is also its advantage. The reports generated by this method do not accurately reflect the assets, liabilities, revenues, and expenses of an individual or organization.
• Specific accounting considerations to include differentiating between earned revenue and unearned revenue would render the financial report distorted. The report might also communicate an unhealthy financial condition due to lack of details.
• Note that unearned revenues include any advance payments for future delivery of products or services. Essentially, they are liabilities. Cash accounting reports these unearned revenues as assets.
• The method is also not in accordance with certain accounting standards, such as the Generally Accepted Accounting Principles or the requirements set forth by the U.S. Securities and Exchange Commission for publicly-traded companies.
Advantages and Disadvantages of Accrual Accounting
The following are the pros or advantages and applications of accrual basis accounting:
• Accuracy is a major advantage of accrual accounting over cash accounting. Studies have revealed that it performs better than cash basis accounting because it provides more and comprehensive information, and provides better comparative results.
• This method allows individuals and organizations to understand their cash flow and balance sheet further because it involves itemizing and differentiating between earned revenues and unearned revenues.
• Accounting standards across the globe to include Generally Accepted Accounting Principles promote the use of this accounting method. Regulatory bodies such as the U.S. SEC and revenue collection agencies require the use of accrual accounting.
• Understanding the difference between earned revenue and unearned revenue would allow individuals and organizations to understand their financial status, especially their periodic sales performance and their liabilities or obligations.
• In addition, the method allows accounting for outstanding commitments and prepaid cash receipts such as retainer fees or advance payments.
The following are the cons and disadvantages of this accounting method:
• When compared to the cash basis method, accrual basis is more complex and, thus, requires more effort in bookkeeping. The additional effort can make it more costly, especially for individuals and small businesses.
• Individual freelancers, sole proprietors, and other businesses with small revenues and client base might be better off using the cash basis method.
• Note that this method does not readily communicate the cash flow. A separate statement of cash flows must be presented along with the balance sheet, income statement, and other financial statements.
Cash Accounting vs Accrual Accounting: The Difference in a Nutshell
The cash basis method of accounting involves recording of revenue when cash or payment is received and recording of expenses when payment is made. On the other hand, in the accrual basis method, revenue is recorded when it is earned, and expenses are recorded when they are incurred, regardless of when payment is received.
Income recognition in cash accounting only involves receipt of payment. However, in accrual accounting, income is only recognized when a product is delivered, or service is performed. Advance payments such as retainer fees are considered as unearned revenue and not actual income under the accrual method.