What’s the difference between the cash and accrual methods of accounting?
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What’s the difference between cash and accrual?
The cash basis and accrual basis of accounting are two different methods used to record revenue and expenses for accounting purposes. The main difference between accrual and cash basis accounting is in the timing of when revenue and expenses are recognized. The results of the two methods are similar over time, but results between cash and accrual-based financial statements can differ substantially in the short term due to when revenue and expenses are recognized.
Cash Basis Method
Under the cash basis method, revenue is recognized on the profit and loss statement when cash is actually received, and expenses are recognized only when cash is paid out.
The cash method is typically used by small businesses because it’s easy to use. If a company’s revenue is greater than $5 million per year, the IRS requires the business to use the accrual method of accounting.
- Simpler to use and quicker to learn.
- Less subjective – transactions are recorded when cash is received or spent, so there’s no need to create rules or make subjective decisions.
- Taxes don’t need to be paid until the money is received.
- No need to track accounts receivable or payable.
- The timing of revenue and expenses can significantly affect operating results. For example, the cash method doesn’t account for expenses until they’re paid, which may lead you to believe you’re having an excellent month if you happen to receive a lot of cash in one month, when in reality the month may be unprofitable.
- The irregular timing of revenue and expenses leads to significant variations between accounting periods, by months, quarters, or years.
Under the accrual basis method, revenue is recognized when it’s earned and expenses are recorded when the company is obligated to pay them.
The accrual method recognizes revenue when a product or service is delivered to a customer with the expectation that money will be received in the future. In other words, money is accounted for before it’s received. Likewise, expenses are recognized when the company is obligated to pay them. For example, if a company places an order for $100,000 of inventoryProducts held for resale to a company’s customers. See Als... from a supplier, the accrual method immediately recognizes the transaction as an expense, even though no cash has been paid.
The accrual method records account receivables and payables. The accrual basis is used by all large companies and is required for tax reporting purposes when annual revenue exceeds $5 million.
- Earnings are smoothed out over time, regardless of when cash is received or spent.
- More accurately represents actual financial results.
- Can provide a more accurate picture of the profitability of a company.
- More complicated to use since it’s necessary to account for items like unearned revenue and prepaid expenses.
Acme Company sells widgets.
If Acme sells $1 million worth of widgets on January 1st and receives payment on March 15:
- Cash Method: The transaction is recorded when Acme is paid (March 15).
- Accrual Method: The transaction is recorded the day the sale was made (January 1st).
If Acme orders $500,000 of supplies on July 1st and pays on August 15th:
- Cash Method: The transaction is recorded when Acme pays the invoice for the supplies (August 15th).
- Accrual Method: The transaction is recorded the day Acme places the order for the supplies (July 1st).