What is the Difference Between Cash Accounting and Accrual Accounting?
Cash accounting and accrual accounting are two similar methods of maintaining accurate accounting records. While the two approaches share many aspects in common, there are two key differences that distinguish each method from the other. Essentially, the difference between cash accounting and accrual accounting boils down to the way debits and credits are applied in the bookkeeping process.
To understand the difference, it is first necessary to define each type of accounting process. Cash accounting, which is also known as cash basis accounting, allows for the recognition of income at the time it is actually received. This means that invoiced income is not counted as an asset until payment for the invoice is actually in hand. The same approach is applied to debits, in that any expenses incurred are not posted until they are paid.
In contrast, accrual accounting does recognize income at the time it is earned. As goods or services are invoiced, the invoices are posted and counted as assets. They remain in this state until the face value of the invoice is credited for some reason. In like manner, any expenses are also posted at the time they are incurred or an invoice for those expenses is received, and remains open until the expenses are paid.
Most mid-level and large businesses today tend to rely on the use of the accrual method rather than cash accounting. Doing so allows a business to determine at a glance how much cash is in hand, how much is currently pending in outstanding invoices, and what current expenses are awaiting payment. At the same time, many individuals tend to go with a cash accounting approach for the home budget, tending to post income as it is received and posting payments for expenses when they are actually sent out.
Small businesses sometimes still use the cash accounting approach, which can complicate matters when a small business is approached by another entity put up for sale or merger with another corporate entity. For this reason, it is always a good idea to not assume one method or the other is in use. Taking the time to verify the method used will eliminate a great deal of confusion and miscommunication down the road.
I know of people who run their home finances along the lines of accrual accounting! Of course the growth of credit cards and personal debt probably makes this worse. These days there are plenty of free cash accounting software packages available on the net. I think they are essential for both business and personal financial management.
@yumdelish - If a small business is up for sale a potential buyer wants to know how profitable it is. I think that cash accounting methods may not give the true picture of this to others.
My sister runs a small online company, selling car related products. She buys directly from a Chinese manufacturer and then sells them through her website. She pays for everything upfront, and her customers orders must also be paid in full before goods are dispatched. As a result her accounting book looks really healthy.
If she had to wait on payment from people, and had outstanding debts owed to her supplier, it would be harder to see how viable the business is.
I can see the benefits of accrual vs cash accounting for a larger company, as they will probably have enough income to cover their spending at any particular time. Small businesses on the other hand could struggle to stay afloat if they count issued invoices towards the money available to spend. Just one or two unpaid or disputed invoices could be enough to send them into the red.
Does anyone know why book keeping on a cash accounting basis would complicate any future buyout or merger? I understand that the records would be different, but that doesn't seem like such a problem if it is made clear at the start.
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