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The cash accounting method is a type of accounting that takes into consideration both income and expenses, when payments are made in cash. This payment could consist of either cash received or cash given/paid. In contrast, the accrual accounting method records income as revenue earned while expenses are noted as liabilities. These transactions are noted in the accounting books, without the necessity of cash being paid out or received.
So, which method is best for your business? It depends.
A closer look at the cash method
The cash basis of accounting records the income or expense at the time the cash is exchanged. The cash method is considered an uncomplicated and simpler process. It is also easy to understand and is most often applied to individual or personal finances. Under the cash method, income received is taxable at the time of receipt, while deductions are made at the time of the expense.
This means that a transaction is not recognized until the payments are cleared. If the payment becomes delayed, the process of recording the transaction is also delayed. Thus, the cash method can prove to be an inaccurate measure of the company’s accounts.
Although it seems easy to maintain, the cash method could also depict a company’s income as being highly inconsistent. For example, if company A follows the cash method, and it receives a high-value project, the company cannot record any revenue earned until they are paid for the project. This means that if it is a long-term project, the company’s income records will not show any revenue as earned until the actual payment is made. This can result in certain periods showing limited income, while others show as high-revenue periods.
Unfortunately, this can lead to an inaccurate depiction of a company’s financial status. These discrepancies could have repercussions when preparing tax returns or seeking loans and financing.
A closer look at the accrual method
The accrual method is the opposite of the cash method. Regardless of when the cash exchange occurs, a transaction is recorded in the accounting books. This method accounts for expected revenue, as well as credit payments. As a result, it is a more accurate record of a company’s current status.
The accrual method is based on the principle that if a sale or economic transaction has occurred, then cash will exchange hands at some point. Records in the account books thus reflect the point at which the transaction took place. Typically, accrual method entries for income are noted in a column termed as accounts receivable. Regardless of actual cash changing hands, the entry in the account books indicates income received.
The accrual method, in contrast to the cash method, recognizes that long-term financial transactions can reflect upon a company’s current financial status. Because of the accuracy required of this method in outlining the financial status of a company, it is more prevalent among larger businesses.
Satish Patel, CPA
President, Analytix Solutions
Satish Patel, Founder-CEO of Analytix Solutions, has more than two decades of experience as a CPA. He has also advised small and mid-sized businesses on diverse matters such as valuation, accounting, and finance. His experience extends to raising capital and arranging for finance from angel investors.
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