What is the difference between cash and accrual accounting?

Cash vs Accrual Accounting

There are two different ways to record business transactions: cash-based accounting and accrual accounting. The main difference between the two is the timing of recording revenue and expenses. In the cash basis of accounting, revenue is recorded when cash is received from the customer, and expenses are recorded when a payment is initiated to the customer, regardless of the period when it occurs. In the case of accrual accounting, revenue and expenses are recorded in the period when they are consumed, irrespective of cash receipts and payments or not. The key difference is the timing of the recognition of revenue and expenses. Recording revenue and expenses is delayed on a cash basis until the cash receipt from the customer and the cash payment to the suppliers.

Understanding the difference between the cash basis and the accrual basis, for example:

A company sells $20,000 of green widgets to the customer in March and buys office supplies worth $1000 in May. However, the customer pays the invoice amount in April and the payments to the supplier in June. Revenue Recognition: The company recognizes the revenue of $20,000 in April when the customers make the payments. Whereas, in accrual accounting, the seller records the sales in March when it issues an invoice to the customer, irrespective of whether cash is received or not. Expenses Recognition: In the case of cash accounting, the company recognizes the purchase worth $1000 in June when it pays the bill. However, in the accrual method, the expenses will be recorded for May when it receives the supplier‘s invoice.

Advantages and disadvantages:

Cash basis accounting:

The main benefit of using cash-based accounting is easy cash flow management. It takes into account only cash receipts and payments. It tracks the company’s cash flow in real-time, just by going through the cash and bank balances instead of examining the receivables and payables. Thus, it provides a clear view of the company’s cash position. However, the cash method overstates the financial health of the business, showing rich cash flow. And on the other side, it has larger payables exceeding the cash on the books and current revenue. It would seem that the company is earning a profit for investors. But in reality, the company is losing its cash flows against pending payments.

Accrual basis accounting:

Although the cash method gives a real-time picture of the business’s cash flows, it fails to capture profitability in the true sense. The accrual method provides an accurate picture of the financial health of the business in the long term. Revenue and expenses are recognized and recorded immediately. It helps to analyze trends and manage finances as it manages cash flow by taking account of receivables and payables. However, the accrual method fails to track the cash flow requirement for the short term, thus suffering a cash shortage even if the company is doing well in the long term. It makes the accounting process complicated at the time of accounting for unrealized revenue and prepaid expenses.