What is the difference between accrual accounting vs cash accounting?
"Accrual accounting vs cash accounting?" This is a question that comes up many times when it comes to recording income and expenses. What the difference is between the two methods, their advantages and disadvantages, and when you can use them, we explain in this article.
In accrual accounting vs. cash accounting, the question is which method should be used to record revenues and expenses. In accrual accounting, revenues and expenses are booked when transactions are made but no money has flowed yet.
In cash accounting, income and expenses are only taken into account after the transactions have been completed, i.e. when money has actually been received in or has flowed out of an account.
Accrual accounting records the expected transactions (accounts payables and accounts receivables), whereas cash accounting records only the actual transactions. Accrual accounting is mainly used by large companies, as this method provides a more accurate picture of the financial situation. Cash accounting, on the other hand, is used by sole proprietorships and small companies because it is less time-consuming.
A company issues an invoice for £1,000 to a customer on 3 May 2022, which must be paid by 17 May 2022. The company applies accrual accounting. It therefore enters the amount of £1,000 for 3.5.2022 into its system under accounts receivable.
At the same time, it receives an invoice from its supplier on 3.5.2022 for £2,000 to be paid by 30.5.2022. This invoice is also entered into the system on 3.5. (accounts payables), even if the payment is not made until 30.5.
A sole trader uses cash accounting. He issues an invoice to his customer on 3.5.2022 for £1,000 with a payment date of 17.5.2022. The customer's payment is received in the sole trader's bank account on 16 May 2022. On this day, he then also records the receipt of payment, even though he issued the invoice earlier.
He pays an invoice of £500 received from his supplier on 3.5.2022 on 20.5.2022. He does not record the expense until that date because the money has not left his account until then.
Since the accrual accounting method records accounts receivables and accounts payables, it more accurately reflects the profitability of a company. Fluctuations in income and expenditure are balanced out by this method, which makes it particularly suitable for a long-term view of the company's success.
Using this method, finances and investments can be planned for the long term, as those responsible can see exactly what income and expenditure they can expect in future months.
The accrual accounting method does not monitor cash flow. This can lead to a company looking profitable when only accounts receivables and accounts payables are monitored, but the company can still suffer from cash flow problems.
Another disadvantage of this method is that it is more complicated because sales that have not yet been received as well as payments that have not yet been made have to be booked and monitored. With very many transactions, an accountant must then be hired to take over this task.
The biggest advantage of the cash accounting method is its simplicity, because only account inflows and outflows have to be taken into account. If a company has only a few accounts or few transactions, the accounting effort is very low. Since the bookkeeping here can usually be done on the side by the managing director, this method is mainly used by sole proprietorships and small businesses.
Another advantage is that with the cash accounting method a company always has its liquidity in black and white. For short-term planning (e.g. on a weekly basis), this method is therefore more suitable than the accrual accounting method.
The cash accounting method can be misleading about the actual financial situation of a company. For example, it may have a lot of cash receipts in a certain period and thus generate a large cash surplus.
On the other hand, this method does not show which liabilities the company will have to meet in the coming weeks and months. If, for example, it has a very high invoice to pay in a fortnight, this will push liquidity down again.
When it comes to accrual accounting vs cash accounting, the question of which method is better for small businesses cannot be answered in a general way. Companies that are obliged to prepare accounts or have an annual turnover of more than £150,000 may only use the accrual accounting method.
Companies or self-employed persons with an annual turnover of £150,000 or less are allowed to use the cash accounting method. However, they are free to use accrual accounting if it is advantageous to them.