As a business grows and prospers, the need for a reliable recording and understanding of their daily transaction becomes more evident. Moreover, the necessity of hiring a professional accountant to apply the fundamental principles of accounting can no longer be ignored.
However, before an accountant could even begin to record the very first journal entry, they would need to decide on some important matters first. And no other choice is more significant than the choice between accrual and cash method.
The accrual basis and cash basis are two of the most common methods of recording transactions. They determine the timing and valuation of most account records. Every type of business can only be best accounted for by either one of them. Thus, the choice between the two is one of the hardest and most critical decisions a business needs to decide.
Lucky for you, we have created this simple article to guide you on which accounting method best suits your type of business.
Accrual Basis Of Accounting
Also known as the accrual method, the accrual basis is the most commonly used method between the two. According to this method, revenues may only be recognized when they are earned. This means, getting paid for a service, does not automatically permit you to record an income in your income statement. It is necessary that you have performed the service first before you can say you can do so.
The expenditures of your business, on the other hand, may only be recognized when either it has been actually used, or when its related income has been recognized. For example, a rim of paper that you have previously bought may not be recorded as an expense until they have been printed on or disposed of. (1)
Pros And Cons of The Accrual Method
The accrual method is preferred by many accountants as it helps represent the real value of the business more than the cash basis. This approach also follows the matching principle of accounting. According to the matching principle of accounting, related incomes and expenses should be recognized at the same time or period.
Hence, the accrual basis can represent a business’s performance for a particular period more accurately and reliably. However, one of the most significant issues of the accrual method is that it requires more effort to implement.
Accountants who use this approach are needed to monitor and remember certain accounts that need to be adjusted due to subsequent events. Another problem is that the recording of incomes and expense do not usually coincide with the issuance of receipts and invoices.
This requires accountants to do some guesswork to value subsequent adjustments in particular account titles. Lastly, the rules and regulations of the accrual method are far more extensive than the cash method; thus, requiring accountants to know hundreds if not thousands of principles and standards.
Who Must Use The Accrual Method Of Accounting
The accrual method is most suitable for businesses that have a few recurring or many, but similar, transactions. Using the accrual method in companies that have hundreds or thousands of unique products can be very troublesome if not impossible an accountant to perform.
Some businesses that are recommended to use the accrual method are:
- Car dealerships
- Groceries
- Services Companies
- Computer Stores
Cash Basis of Accounting
The cash basis of accounting is a simpler and straightforward counterpart of the accrual basis. The recording and recognizing of income and expenses through this method is based on the physical movement the cash account.
Hence, revenues are recognized when the business gets paid, and the costs are recorded the company pays. This method is used by many small and medium businesses. This is because it is incredibly easy to implement even by someone who has minimal training in the accounting profession.
Pros And Cons Of The Basis Method
As was stated above, the cash basis of accounting is simpler and easier to use for any business. It also consumes lesser time to implement since fewer analytical procedures are needed to value various account. Furthermore, the cash basis is cheaper for smaller companies because there is a lesser need for them to hire well-trained accounting professionals.
However, all these advantages come with a price. The cash basis is rarely able to represent a business’s real value correctly. One common reason for this is that companies often buy their supplies in advance. Hence, if these supplies were to be expensed immediately, even those not yet used by the company would pull their net income down. (2)
Who Must Use The Cash Method Of Accounting
The cash basis of accounting is most suitable for small and start-up businesses. This is because they can invest the money they would use to hire a professional accountant into other growth related sectors of their company. It is also recommended for companies who have many unique products and expenses but have not yet implemented more advanced automated accounting systems.
Some businesses that are recommended to use the accrual method are:
- Mom and Pops type of shops
- Newly opened café shops