Cash Basis or Accrual Basis Accounting: Which one to Use?
When setting up an accounting system for the first time, a business will find that it can generate financial reports under two different methods: the cash basis and the accrual basis. Many new business owners will ask which method they should be using and what the difference is between the two. Ultimately, each method has its own use and it is important for business owners to understand when either one is needed.
Cash Basis
The cash basis of accounting is the simplest method and the easiest to understand. Under the cash basis, a business records revenue when it collects money from customers and expenses when it pays money to vendors. Most new businesses will prioritize the cash basis of accounting, as it clearly depicts their cash flow over a given period and helps to detect imminent funding needs. It also takes the least amount of effort to maintain from day to day, thus allowing management to focus more of its efforts on growing the business.
Accrual Basis
The accrual basis of accounting is more complex, but it provides a more complete picture of a business’ financial position and outlook. Under the accrual basis of accounting, a business records revenues when they are earned (i.e. when it provides services or delivers products to its customers), and expenses when they are incurred (i.e. when a vendor provides services or delivers products to the business). As a result, the balance sheet is more extensive under the accrual basis, and may include accounts such as:
- Accounts Receivable: Money owed from customers for services provided or products delivered by the business.
- Prepaid Expenses: Money paid in advance by the business for services yet to be provided (i.e. insurance coverage, software subscriptions, rental periods, etc.)
- Accounts Payable: Money owed to vendors for services provided or products delivered to the business.
- Deferred Revenue: Money collected in advance from customers for services yet to be provided (i.e. fees received at the beginning of a subscription period).
The accrual basis of accounting is much more useful in making critical decisions when managing or evaluating a business, as it informs financial statement readers of the cash flows to be expected in the future. To that end, major lenders and investors will typically require a business to provide financial statements using the accrual basis of accounting before making a significant investment.
Overall
Business owners and managers should learn to utilize both the cash basis and the accrual basis of accounting when appropriate. Modern accounting systems, when set up properly, can produce financial statements under each method and alternate seamlessly between the two at the click of a button. It would be highly prudent to work with an accounting professional when exploring these matters to ensure complete and accurate financial reporting.
