The key difference between the two primary accounting methods, cash-base and accrual accounting, is timing. With cash-based accounting, transactions are recorded when cash actually changes hands. With accrual accounting, transactions are recorded when they occur, regardless of when the cash is actually received or paid. Most of the time, both methods are approved accounting methods for tax purposes. However, General Accepted Accounting Principles (GAAP) requires all public traded companies to use accrual method for their published financial statements. Detailed differences and advantages / disadvantages of the each are discussed below.
- Revenue and expense reorganization: under cash basis accounting, revenue is recognized only when cash is received; while under accrual accounting, revenue is recognized when products are delivered or services are provided which means it is reasonable to expect that cash will be received in the future. Likewise, under cash basis accounting, expense is recorded as soon as the cash is paid; while under accrual accounting, expense is not recognized until the service is completed or all goods are received or/and installed. Therefore, terms like “unearned revenue” (when revenue is recognized after cash has been received) and “prepaid expense” (when expense is recognized after cash has been paid) are used in accrual accounting.
- Advantages and disadvantages of the cash based accounting method: the cash method is simple to implement by just tracking the cash flow and provides an accurate representation of cash activities. However, it is not a good method to measure long term profitability as it does not recognize receivables and payables. It is possible that the company is earning a profit with cash method but in fact it is losing money.
- Advantages and disadvantages of accrual accounting method: the accrual method shows the income and debts more accurately but loses track of cash flow which may result in a serious cash flow problem. It is also more complicated and expensive to employ than the cash method.
Both methods have their drawbacks and can only provide partial information of a business’s finances. Whichever accounting method is primarily used, the firm should always do periodic internal reports looking at things on both a cash and accrual basis to fully understand the firm’s performance and make sure there is enough cash on hand to operate the business.