There are two ways to record accounting transactions in the world of accounting: cash basis and accrual basis. The accrual basis is based on recording the expenses and revenues, whereas the cash basis method of recording involves immediate recognition of any expenses and revenues.
In other words, when money is transferred between the two parties involved in a transaction, the cash basis of accounting immediately recognizes the costs incurred and revenues earned. Whereas, the accrual basis of accounting records revenues as they are earned and bills expenses as they are incurred. Let's learn about the same in detail.
Cash basis accounting
In case of cash base accounting, it records revenues and expenses when cash is received and paid. Receivables and payables are not accounted for using this method.
Many small businesses prefer the cash basis of accounting because it is easier to maintain. There is no need to keep track of payables or receivables, and it is easy to tell when a transaction has taken place (the money is in or out of the bank).
The cash method is also useful for tracking how much cash the business has at any given time; you can check your bank balance and understand the exact resources available to you.
Furthermore, because transactions are not recorded until cash is received or paid, the business's income is not isn’t taxed until it’s in the bank.
Accrual basis accounting
Accrual accounting is a form of accounting where revenues and expenses get recorded when they are earned as opposed to when they are received or paid. For instance, you would record revenue when a project is finished rather than when you are paid. This approach is more commonly used than the cash approach.
As opposed to cash accounting, which cannot give a long-term picture of the business, an accrual basis gives a more accurate picture of income and expenses over time.
The disadvantage of accrual accounting is that it does not provide any awareness of cash flow; a company may appear to be very profitable while actually having empty bank accounts.
Accrual accounting without careful monitoring of cash flow can have significantly devastating results.
Differentiating accrual and cash accounting
· When cash is received, revenue is seen.
· Recognizes expenses when money is spent
· Taxes are not paid on funds that have not yet been received.
· Small businesses and sole proprietors with no inventory are the most likely to use it.
· Revenue is recognized when it is earned (eg. when the project is complete)
· Recognizes expenses when they are billed (for example, when you receive an invoice).
· Taxes paid on money still owed to you.
· Required for companies with a revenue of more than $25 million.
In conclusion, cash basis accounting records revenue and expenses at the time that actual payments are made or received. It does not take into consideration the timing of the transactions that generate them. Contrarily, accrual accounting records revenue and expenses as the transactions occur, before any money is received in or paid out.
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