Accounting is an essential part of a business to record the monetary transactions of the day-to-day activities. An individual has to choose between cash-basis accounting or accrual-basis accounting.
The business owner must understand the difference between cash and accrual accounting before choosing the SMSF accounting services. A cash accounting records transactions when there is an inflow or outflow of cash, ignoring the period to which the cash belongs. While the accrual accounting record transaction based on their occurrence.
Both methods are beneficial and have disadvantages that an enterprise must know while choosing. It has to choose between cash and accrual, whatever suits the most to its workings in an efficient manner.
What is Cash Basis Accounting?
The cash basis of accounting records revenues and expenses when there is a cash flow, whether inward or outward. It is the earliest form of accounting for recording transactions in a business. In the cash accounting method, only cash ad bank transactions are relevant despite the period they belong to and the mode of payment (whether E-payment or cash/bank).
As this method has nothing to do with a transaction in which cash is not involved or a double entry system, it does not have any receivables or payables. This method is more beneficial to a small business organization because small entities generally deal in cash/bank transactions.
Benefits of Cash Accounting
The cash accounting method is practical for a small business, and the benefits of this method are-
1. Easy to use
The cash accounting method is easy to apply for a beginner. The accountant will record the transaction when the cash is received or paid.
2. Easy tracking of cash available
It gives a clear picture of funds available in cash at the time of need. It helps manage an organization’s expenses more efficiently.
Tax benefits – This method is beneficial in legally reducing the tax burden. The accountant records all income and expenses when they represent cash. It can provide control over the timings of large payments.
Downsides of Cash Accounting
The cash-basis accounting has some disadvantages that an organization can’t ignore. The following are the downsides-
A) Fair picture of the business – records only cash transactions, can provide immediate availability of cash or balance available in the bank but doesn’t depict true profitability. It does not record receivables/payables that can affect the accuracy of the balance sheet.
B) Accuracy of profits – The cash accounting method only record cash transaction of a particular financial year, so the pending bills and invoices remain unrecorded. That is why the calculation of actual profits is not possible.
C) Risky – In the cash accounting method, the business can not record the sale or purchase until there is a cash flow. So the account can’t measure the actual debt the organization has to pay.
What is Accrual Basis Accounting?
The accrual accounting of the business records transactions at the time of their occurrence rather than the payment received/paid. It allows the record of transactions of actual as well as expected cash flows.
The prime difference between cash vs accrual accounting is the time of recording the transaction. In accrual accounting, emphasis is on all the receivables/payables/provisions along with cash transactions.
Benefits of Accrual Accounting
Accrual accounting is more beneficial to a large-scale business organization. The advantages of accrual basis accounting are as follows –
1. Present a fair picture of the financial position
In general, business records transactions on an accrual basis means when they are incurred so that they can present an actual financial state of the entity.
2. Preferable for GAAP
The Generally Accepted Accounting Principles prefers the accrual method of accounting over cash basis accounting because this method is more accurate than the cash accounting method.
3. In the best interest of the investors
As accrual accounting presents the fair value of the business transactions, the investors are more comfortable with this method.
Downsides of Accrual Accounting
Accrual accounting has some downsides, and these are –
1. Need for experts
There is a possibility that a beginner doesn’t know accrual accounting as there are laws and accounting principles for this method to record transactions. So a business must need an expert to handle the accounting on an accrual basis.
2. Tax return
A firm has to pay tax on the income it hasn’t received yet, as it records transactions on their occurrence. And also they can help with SMSF through SMSF tax return.
3. Complex process
The process of accrual accounting is more complex and time-consuming than the cash accounting method.
4. Cash flow statement
This method record transaction when they occur, so there are chances that the cash flow statement does not represent the actual cash available to the business owner.
Cash-Basis v/s Accrual-Basis Accounting: What’s the difference?
To choose between a cash or an accrual accounting method, a business owner has to compare and analyze both. For comparison, he must know the difference between cash and accrual accounting in Australia.
We can understand the difference between cash vs accrual by the following points –
1. Revenue recognition
In cash basis accounting, the cash flow will decide the time of revenue recognition. While in accrual accounting, the revenue will be recognized as soon as the organization earned it.
2. Recognition of expenses
Similar to revenue recognition in cash accounting, the accountant records expenses when there is a cash outflow. While accrual accounting records expenses in the year or month to which they relate.
3. Accounting system
As per the Generally Accepted Accounting Principles, the financial statements prepared by an entity should be according to accrual accounting because it records transactions in a double-entry system. The cash accounting method uses a single-entry system of accounting.
4. Accounting of receivables and payables
The cash accounting method doesn’t record account receivable and payables because receivables and payables do not have cash in them. Accrual accounting presents them in a balance sheet to correctly record them.
5. Taxes
The effect of taxes is different in both methods of accounting. For example, the tax payment on a sale transaction is at divergent times under both. Under cash accounting, the tax payment will be at the time of receiving the cash, while under accrual basis, the tax payment will be at the time of sale.
6. Reporting of assets, liabilities, and provisions
An organization has to prepare an income statement, balance sheet, and cash flow statement for its financial reporting of a financial year. Under the cash accounting method, the cash flow statement will provide the actual amount of cash/bank available for a business in hand. But the balance sheet doesn’t include receivables and payables, hence does not reflect a fair view of the financial statement.
Under accrual accounting, the recording of transactions is as per their occurrence or happenings, and the balance sheet will depict the fair picture of the financial statement.
Cash vs Accrual: What is the best type of Accounting for Small Businesses?
A small organization should analyze about what’s the difference between cash and accrual accounting.? After analysis, it can decide which type of accounting suits best to it. The accountant must consider the following points –
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The size of the business
If an organization is a sole proprietor, it should select the cash accounting method. Cash accounting is beneficial for small businesses because it does not require experts and is easy to implement. But if the turnover is more than $10 million per year, the organization should apply an accrual accounting method according to the rules prescribed by the Australian Taxation Authority (ATO).
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Future planning
If a small business entity expands its business activities in the future, it should apply the accrual method of accounting. It will also depend on the employees the entity is hiring because accrual accounting will require professional accountants.
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Mode of Accounting
The mode of accounting, whether electronic or document form, will affect the accounting method. The accrual method is more complex than the cash accounting method. So if an organisation records transactions electronically, it can use accrual basis accounting.
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Complexities of transactions
When there are complex transactions in the day-to-day activities of the business, then the entity must use the accrual accounting method. But when the transactions are simple, then the cash accounting method is preferable.
If a small business firm plans to finance the business from outside investors, the accruals basis of accounting is the best choice as it concerns Generally Accepted Accounting principles. However, if the firm has most transactions in cash, it should apply cash basis accounting.
Conclusion
Accounting is the backbone of the business to record monetary transactions and measure profitability. The above discussion on the difference between cash and accrual accounting clarifies a reader’s mind about the strengths and weaknesses of both methods.
A business owner should carefully choose the method of accounting to prepare its financial statements. To manage the books of accounts of a business organization, the firm will need a professional accountant (for the accrual method) or a bookkeeper (for the cash accounting method).
The prime difference between cash vs accrual accounting is the time of revenue recognition. Under cash basis accounting, the revenue recognition will be at the time of receiving the money, and the acknowledgment of expenses is at the time of cash paid. Under an accrual accounting method, the recognition of revenue/expenses will be at the time of the occurrence of the transaction.
A small business should choose a cash basis accounting if it does not have many transactions involved in its business activities. But if it has complex transactions and a turnover of $10 million for a financial year, then it should apply the accrual method of accounting as per the rules set by ATO.
The Generally Accepted Accounting Principles prefers to use accrual accounting as it records all the receivables/payables, provisions, or contingencies in the books of accounts.
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