How is accrual accounting differs from cash-basis method of accounting?

Answer:

The main difference between accrual and cash basis accounting is the timing of when revenues are recognized and costs. The cash method is a more immediate recognition of income and expenses with the accrual method focuses on the expected income and expenses.

Cash Method

  • The company reported on the statement of profit and loss only when the cash is received.
  • Expenditures are recorded only when the money paid.

The cash method is mostly used by small businesses and for personal Finance.

The Accrual Method

  • Revenue is recorded when it is earned. Usually a company is registered before the money. In contrast to the cash method to the accrual method revenue when the product or service provide the customer with the expectation that the money will be paid in the future.
  • The cost of goods and services are recorded despite the lack of funds that paid more for these expenses.

Example of calculation and methods

Let’s say you have a business that sells cars. If you sell $ 5,000 cars under the cash method, that amount is not recorded in the books until the customer hands YOU the MONEY or you get a check. In accordance with the accrual basis, $5,000 is recorded as profit from the sale even if you receive money in a few days or weeks later.

The same principle applies to spending. If you get a bill for $1,700, under the cash method, amounts are not added to the books until you pay. However, in accordance with accrual accounting, $1,700 is recognized as an expense the day you get the bill.

The Advantages And Disadvantages Of Both Methods

The advantages of the cash method are its simplicity, since it considers only the cash paid or received. Tracking the company’s cash flows is also easier with the cash method.

Disadvantage of the cash method is that it may overstate the health of the company, which is rich, but has a large amount of payables, which is much in excess cash on the books and current income. The investor may conclude the company is making a profit, when in reality the company is losing money.

The advantages of accrual accounting is that it includes accounts payable and receivable and, as a consequence, is a more accurate picture of the profitability of the enterprise, especially in the long term. The reason for this is that the accrual method reflects all revenues when they are earned, and expenses when they are incurred.

For example, a company may have sales in the current quarter, which would not be recorded under cash basis because income is not expected until next quarter. The investor may conclude the company is unprofitable, when in reality the company is doing well.

The disadvantage of accrual accounting is that it does not track cash flows and, as a consequence, cannot account for the company with large cash deficits in the short term, but it is profitable in the long term. Another disadvantage of accrual accounting is that it can be more complex to implement, since it is necessary to take into account elements such as unearned revenue and prepaid expenses.

Bottom Line

The accrual method is most often used by companies, particularly publicly-traded companies. One of the reasons for the popularity of accrual accounting is that it smooths profit overtime, because it takes into account all income and expenses as they occur, not the time the record breaks under the cash method. For example, under the cash method, retailers will look very favorable in the 4th quarter, as consumers buy for the holiday season, but will look unprofitable in the 1st quarter, as reduced consumer spending after the holiday rush.

Both methods have their advantages and disadvantages, and each of the financial condition of the company. Understanding how accrual accounting and cash flows with the cash method is important when making investment decisions.

Learn more about financial statements in our article, what you need to know about financial statements.

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