All publicly listed companies are required to adhere to the generally accepted accounting principles (GAAP), issued through the standards of the Financial Accounting Standards Board (FASB). As such, these entities are required to perform their accounting based on the accrual basis as opposed to cash basis accounting. But what is accrual accounting and what is the difference between it and cash based accounting? Also, why is one method preferred over the other? Let’s take a closer look at the answers.
What is cash basis accounting?
In simple terms, cash basis accounting is recorded whenever a company actually gets paid. Even though the name uses the word “cash”, it certainly doesn’t have to be a cash payment for it to be recorded using this method. Electronic payments and cheques are perfectly acceptable as well. The key feature of cash basis accounting is related directly to the timing when the payment is received. It also counts for expenses.
Say that you receive your electricity bill today, it should be recorded as an expense with today’s date. But what about income or sales? The same principle applies. You may sell 10 apples today but only get paid for them next week. This means that you’ll only record the sale next week.
There are some benefits of this accounting method and generally these include that it is far simpler to calculate than accrual accounting. It also shows how much cash you have on-hand right now. It’s also an easier way of calculating taxes.
On the other hand, it’s not the preferred accounting method for two main reasons. The first is that it could show you are profitable or cash-flush, simply because your bills have been unpaid. It is also not helpful when making management decisions. Why? Because it offers only day-to-day views of your business’ finances.
What is accrual accounting?
Accrual accounting is considered a more complex and sophisticated method of accounting and it is the generally accepted accounting method for most businesses. Once again, it deals with the timing of payments. However, instead of recording them as and when cash/sales and/or expenses are paid, it records them immediately. This is generally the accrual meaning in accounting.
Therefore, even though you might get paid for your 10 apples next week, the income will be recorded as a sale today.
As such, accrual accounting offers a much more accurate picture of the business’ performance and its finances, enabling management to make better financial decisions. Also, it’s a great way of helping investors see the bigger, long-term picture of your business and its levels of profitability as opposed to the cash basis accounting method.
Why is accrual accounting preferred over the cash basis?
Accrual accounting is preferred over the cash basis because it is a far more accurate representation of a business’ finances and its financial position. It enables investors to see what money is coming in over the long-term, as opposed to just looking at your business finances narrowly. For example, you may have sold 20 apples during the Christmas holiday period, but this will not reflect the true financial position of your business over the upcoming year.
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In short, accrual accounting is a much more accepted and recognised method of performing and managing one’s business finances. Although it is more complex than the cash basis, it has numerous advantages. Consequently, it requires a trained and experienced accountant to help you file your tax returns and manage your business’ finances better. If you need any help with your bookkeeping or accounting needs, you’ve come to the right place. At Tax Navigator, we offer comprehensive and professional accounting services to ensure your business finances are as streamlined and efficient as possible. Don’t hesitate to get in touch with us today!
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