By definition, accounting practice involves the process of reporting the daily financial activity of a business entity. It is necessary for producing the required annual financial statements of a company. There are different accounting methods that businesses can use to record their financial statements.
Every country has their own accounting principles that companies must adhere to. In the US, the generally accepted accounting principles (GAAP) is issued by the FASB. It consists of accounting principles, procedures, and standards that companies must follow to prepare their financial statements.
There are two prominent accounting methods used by CPAs for their accounting practices. They are cash accounting and accrual accounting.
- Cash Accounting
In this method of accounting, revenue and expenses are recorded only when they are received and paid. That is, a sale is only recorded when payment is received, and expenses are captured when bills are paid. Cash accounting method is the most used for small businesses.
- Accrual Accounting
Under the accrual accounting, revenue and expenses are recorded once they are earned or consumed. You don’t have to wait until a payment is received or a bill is paid. It is mostly used by public organizations that want its financial statement audited.
Accrual accounting is considered by many to be the most theoretically correct accounting method. It requires an advanced knowledge of accounting.
Now, what’s the difference between these two accounting methods?
The main difference between cash accounting and accrual accounting is the time when revenue and expenses are recorded or captured. While accrual accounting focuses on anticipated revenue and expenses, cash accounting only recognises what’s on ground. None of these two methods of accounting truly shows the financial health of an organization. And both have their advantages and disadvantages.
The reason why the accrual method is considered the most theoretically correct is because it shows the overall earnings of a company. It levels out all revenue and expenses as they are generated.
Here are the advantages and disadvantages of both cash and accrual accounting methods.
Cash Accounting Methods
It is simple to use and only account for cash paid or received
It doesn’t require greater knowledge of accounting
With cash accounting it is easier to track the cash flow of an organization.
It doesn’t reflect the true financial health of an organization.
When a company is cash-rich, investors might assume the company is making profit while in reality it is making a loss due to large sums of account payables.
Accrual Accounting Method
It shows a more accurate picture of the financial health of an organisation.
It shows the long-term profitability of a company
It includes both accounts payable and receivables
It doesn’t track cash flow. And as a result, it doesn’t account for an organisation’s cash shortage in the short term.
It requires a greater knowledge of accounting
It is sometimes more complex to implement since it has to account for both unearned revenue and yet-to-be-paid expenses.