Choosing Between Cash Basis and Accrual Accounting

Accounting is an essential aspect of any business. There are three main methods of accounting:

  • Cash basis
  • Accrual accounting
  • Modified cash basis

Each method has its pros and cons when applied.

The two accounting methods that have a major difference in their implementation are cash basis accounting and accrual accounting.

The fundamental difference between these depends on the timing of when revenue and expenses are recorded in the accounts. After weighing their pros and cons, you can determine which method is best suited for your company’s accounting needs.

Cash Basis Accounting

Cash basis accounting is the simplest method of accounting. It is commonly used by small businesses for bookkeeping purposes.

In cash basis accounting, a business only uses cash accounts to record expenses and income. This simply means that income is recorded only when you receive cash from customers; expenses are recorded only after you pay cash.

Advantages of Cash Basis Accounting

  • Less expensive compared to other methods
  • Easy to use
  • Does not require a deep knowledge of accounting
  • Easy maintenance
  • Limited information to audit
  • Advantageous for small businesses

Disadvantages of Cash Basis Accounting

  • Cannot track long-term liabilities such as loans or inventory
  • Inaccurate representation of cash-rich companies with large liabilities
  • Only cash accounts can be tracked
  • Not ideal for large businesses as it has a restricted use

The balance sheet for cash basis accounting only includes assets, liabilities, and equity. It doesn’t include payable accounts, receivable accounts, or inventory. As such, cash basis accounting doesn’t inform us about unpaid invoices and expenses.

Given below is an example of a cash basis accounting balance sheet:

Asset Account Sub Account Type Balance
Checking Bank account $6,000.00
Savings Bank account $3,000.00
Petty cash Cash $2,000.00
Total assets $11,000.00
Liability Account Sub Account Type Balance
Sales tax collected Sales tax payable $1,400.00
Total liabilities $1,400.00
Equity Account Sub Account Type Balance
Owner’s equity Equity $600.00
Net income $9,000.00
Total equity $9,600.00

Accrual Accounting

Accrual accounting is a complex method of accounting that depends on having a deep knowledge of the subject.

Accrual accounting considers advanced accounts such as payable accounts, current assets, inventory, and long-term liabilities. It records income when a transaction has taken place irrespective of whether the amount is paid yet.

Under an accrual accounting system, expenses are also recorded when you are billed.

Advantages of Accrual Accounting

  • Useful for forecasting future income and expenses
  • Accurate representation of the company’s financial performance
  • Projecting long-term profitability
  • Making financial strategies based on projected income and expenses
  • Accessing different accounts to learn about transactions

Disadvantages of Accrual Accounting

  • Complex to implement
  • Requires deep knowledge of accounting

After implementing an accrual accounting system, your company’s balance sheet will contain significantly more detail about your liabilities and transactions compared to cash basis accounting.

Given below is an example of a balance sheet under the accrual accounting system.

Asset Account Sub Account Type Balance
Checking Bank account $6,000.00
Saving Bank account $3,000.00
Petty cash Cash $2,000.00
Accounts receivable Accounts receivable $2,000.00
Total Assets $13,000.00
Liability Account Sub Account Type Balance
Accounts payable Accounts payable $0.00
Sales tax collected Sales tax payable $1,400.00
Credit memo liability Current liabilities $0.00
Payroll tax liability Current liabilities $0.00
Total liabilities $1,400.00
Equity Account Sub Account Type Balance
Owner’s equity Equity $600.00
Net income $10,000.00
Total equity $10,600.00

Tabular Comparison of Cash Basis Accounting and Accrual Accounting

The table below summarizes how different types of accounts are reviewed under cash basis and accrual accounting.

Type of Account Cash Basis Accrual Basis
Cash Yes Yes
Equity Yes Yes
Income Yes Yes
Cost of goods sold Yes Yes
Expense Yes Yes
Accounts receivable —- Yes
Fixed assets —- Yes
Current assets —- Yes
Accounts payable —- Yes
Long-term liabilities —- Yes
Current liabilities —- Yes

Conclusion

Ideally, cash basis accounting should be implemented by small businesses and accrual accounting should be used in large or publicly traded companies.

Cash basis accounting is simple and easy to use. It only records cash after transactions are completed and it cannot be used to record long-term liabilities, expenses, and inventory.

Accrual accounting is a complex method that involves sophisticated techniques. It yields a more accurate representation of the company’s financial performance compared to cash basis accounting.

Depending on the nature of your business, and after considering each aspect of the methods described above, you should be able to choose the best-suited approach.

Frequently Asked Questions

What is cash basis accounting?

The cash basis of accounting is a method where income and expenses are recorded only when cash payments are received or made.

What are the examples of cash basis accounting?

Cash basis accounting is most commonly used in retail businesses that do not have a large volume of transactions. Physicians, consultants, and other professionals that perform services for clients also use cash basis accounting.

What is accrual accounting?

Accrual accounting is a method where income and expenses are recorded regardless of whether payments have been received or made.

What are examples of accrual accounting?

Accrual-based accounting is more commonly used by companies with high transaction volumes including those listed on public stock exchanges.

What are the differences between cash basis and accrual accounting?

Cash basis accounting is a simpler form of accounting. It does not recognize income or expenses until cash transactions have occurred, while accrual accounting records income and expenses as they occur even if no cash transaction has occurred. On the other hand, accrual accounting is more accurate because it shows each source of income and the expenses related to it. It is also able to provide information on long-term liabilities, assets, inventory, etc.

True is a Certified Educator in Personal Finance (CEPF®), author of The Handy Financial Ratios Guide, a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.

To learn more about True, visit his personal website, view his author profile on Amazon, or check out his speaker profile on the CFA Institute website.