At first, it may be difficult to understand the distinction between accrual accounting and cash accounting, especially for non accountants. However, as you go along and learn about these two things, you’ll see that it’s actually simpler than you anticipated. The distinction between these two systems typically has to do with when to recognize revenue and/or expenses.
The following are the breakdowns of different aspect of the two different accounting system:
As to nature
Regardless of when they were earned or incurred, cash accounting only records income and/or expenses when there are cash receipts and/or cash disbursements. It just means that there is no need to record revenue or expense when there are no cash flows in a certain transaction. In light of this, the calculation for profit is as simple as receipts less expenses. This type of system exemplifies the saying, “Cash is King.”
Contrarily, accrual accounting records revenue and/or expenses whenever they are incurred, regardless of whether there is a cash flow from that specific transaction or not. Cash flow in and of itself is irrelevant in this type of accounting. Revenue minus expenses will be used to calculate profit. The recognition of transactions on account/credit, such as accounts payable and receivable, as well as deferrals and accruals, is the basic foundation of this approach (i.e., prepaid expense, accrued expense).
As to timing
As said in the preceding paragraphs, the existence of cash flows is the only prerequisite for cash accounting. However, accrual accounting recognizes transactions that actually take place.
As to accuracy
Timing-wise, because cash accounting does not keep track of recurring invoices like unpaid bills and/or unearned income, it cannot guarantee the accuracy of financial accounting and/or reporting. Contrary to accrual accounting, it offers a more precise recognition mechanism, which can provide for confidence over reporting.
As to complexity
Cash accounting is straightforward due to the fact that it only recognizes a transaction when there is a flow of cash. However, accrual accounting is far more complex and time-consuming than cash accounting. The reason for this is that a business must monitor or maintain accounts over time, such as recurring sales invoices and prepaid expenses.
Which is preferred?
Putting together the separate views of the latter focal points, one should be aware of the distinction between cash and accrual accounting, as well as the need of knowing when to apply such an approach based on the situation.
Cash accounting is preferred by micro, small, and medium-sized organizations (MSMEs), particularly those that do not primarily carry credit accounts, such as carinderias. The accrual accounting system, on the other hand, is best suited for small enterprises with credit accounts (i.e., subscriptions) and larger corporations.
When it comes to financial management, the accrual accounting method is recommended since it can be utilized for capital budgeting and financial analysis, which is advantageous over creating economic decisions, tactics, and strategies. It provides a more in-depth perspective and knowledge of an entity’s economic and operational performance. Unlike cash accounting, its breadth is limited to a point where it does not include accounts that are critical to financial management.