The Two Accounting Methods
There are two methods which are commonly used for accounting: cash basis and accrual. Both systems have their strengths and weaknesses, but most accounting professionals prefer the accrual method. The main difference between the two lies in how sales and purchases are recorded. What follows is a brief overview of each method and an explanation as to why the accrual method is preferred.
(Note that there is a third hybrid method that is used for small businesses with large inventories, but this method is rarely utilized.)
The Cash Basis
This is the simpler method of the two. In cash basis accounting, transactions are only recorded when money changes hands. If a service is performed on one day, but the client does not pay until two weeks later, the transaction is recorded on the day it is paid. Accounts receivable and accounts payable do not exist in this method.
The cash basis can temporarily reduce tax obligations. If a service is performed in December but is not paid for until January, the income from that service will be on next year’s tax bill and not the current year. A business using this method will not be taxed for income until it has been realized.
Cash basis allows a business owner to see how much cash is on hand, but does not provide an accurate picture of debts and obligations. Because of this, it works well for short-term operations, but is a poor basis for long-term planning.
Summary of Cash Basis Accounting:
- Can defer some taxes because it recognizes revenue when it occurs
- Beneficial if company is strapped for cash (better short-term projections)
- Shows how much money is currently in business accounts
- Poor system for long-term projections due to lack of receivables and payables tracking
- Obscures actual financial standing of business
The Accrual Method
The more complicated system is accrual accounting. This is the more widely used method, although some small business owners prefer the cash basis due to its simplicity. The accrual method recognizes income and expenses when they are incurred, not when cash changes hands. Income and expenses are tracked through accounts receivable and accounts payable.
The advantage to this method is that it gives an accurate picture of how the business is performing -- with knowledge of outstanding invoices and obligations, the owner has a clear idea of the company’s position. In addition, the increased accuracy that comes with the accrual method allows more definite planning for the future direction of the business. Businesses using the cash method may appear healthy because their financial statements show a positive cash flow, but a mountain of unrecorded debt could be sinking the business.
The accrual method also helps in margin and ratio analysis because the numbers present a more complete overview.
Summary of Accrual Method Accounting:
- More complicated than cash basis accounting
- Uses accounts payable and receivable to record unpaid debts and unrealized revenue
- Provides a better picture of the status of the company by showing sales performance, which can then be used for future projections
- Analysis of operating margin and profit margin is easier and more reliable
- Meets GAAP (Generally Accepted Accounting Principles) standards
Although some small business owners prefer the cash method, the accrual method is the preferred system for a company that is looking for stability. The accrual method gives management a better idea of how the company is performing and allows improved planning for the long-term success of the business. Additionally, it is the method that investors and financiers expect to see when examining a company’s finances.
Using cash basis, a company in severe financial distress can appear to be healthy and generating substantial cash flows. This is a “trick” of the cash basis method because liabilities are not recorded until they are paid. With good reason, lenders and investors are usually very suspicious of cash basis accounting because it does not accurately reflect a company’s liabilities.
You may be asking yourself “But how can I be sure of my current cash flows when I’m using the accrual method?” The deficiencies in accrual accounting can be easily overcome by using a financial statement that is often overlooked: the statement of cash flows… but that’s a subject for another blog post!