Accrual Accounting vs. Cash Basis Accounting: Which is Right for Your Business?

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Accounting is the language used to narrate the financial story of a business to its owners, lenders, government, and other shareholders. In the accounting world, two primary methods of accounting are used to record financial data – Accrual Accounting and Cash Accounting. Both of these methods are primarily used to track money, however, each has its own set of benefits and drawbacks. Hence, to clear your understanding and help you choose the right method for your business, we will discuss the key aspects of Accrual Accounting vs. Cash Basis Accounting in this blog.

What is Accounting: In Layman Terms

In simple terms, accounting is a process that helps a business or individual keep track of their money. By definition, it is a process of recording, summarizing, and reporting financial information. It basically records the money that is going in and out of the business. For instance, where the money comes from, where it goes, etc.

All the business transactions such as sales, purchases, etc. are recorded in the accounting system of the organization. Based on this recording, the accountant presents or organizes the financial data to the management team to facilitate efficient decision-making.

Additionally, there are two primary methods used by the accountants to perform this task. In the following section, we will discuss cash vs accrual accounting.

Accrual Accounting vs. Cash Basis Accounting

Cash vs accrual accounting are two separate methods of accounting. This section entails the meaning, advantages, and disadvantages of each method.

Cash Accounting

Cash Accounting is a simple method where transactions are recorded based on the inflow and outflow of cash. In short, when cash changes hands, cash accounting is done. For instance, when a business receives cash, it records revenue, and when it pays cash, it records expenses.

This method is suitable for small businesses and sole proprietors that require a clear picture of their business cash flow. As per the UAE law, businesses with revenue less than AED 3,000,000 can use a cash basis of accounting in their financial statements. However, they can also opt for the other method in exceptional circumstances upon application to the authority.

General examples of businesses that use cash accounting include freelancers, small consultancies, and mom-and-pop shops.

Advantages

The various benefits of cash accounting include:-

Simple and easy: Cash accounting is simple, easy, easy to implement, and understandable for everyone. Thus, this makes it an ideal method for those with limited or no exposure to accounting expertise, such as small businesses.
Accurate reflection of cash flow: Transactions are recorded based on real cash movements. Hence, financial statements show actual cash flow.
Other benefits: There are many additional benefits of using the cash basis of accounting. For instance, it requires no advanced training or education. The business owner can perform all the transactions and access updated information. Moreover, it is quicker, less complex, and allows deferment of taxes by postponing the recognition of income.

Disadvantages

Additionally, cash accounting holds many disadvantages as well, such as –

Limited vision: The cash accounting system works on real cash flows. Hence, business owners cannot have a complete picture of the business. For example, if cash is not received, revenue is not recognized. Similarly, expenses that are not yet paid stay unrecorded.
Non-compliant to GAAP: Cash accounting is not Generally Accepted Accounting Principles (GAAP) compliant. Businesses with significant revenue or complex financial transactions use accrual accounting which is required in GAAP.
Not comparable: Financial reports of businesses using the cash method of accounting cannot be compared to those using accrual accounting. This is because the timing of revenue and expense recognition is different in both methods.

Accrual Accounting

On the other hand, Accrual accounting is a method where the revenue is recognized when it is earned and expense is recorded when it is incurred, regardless of whether the cash is received or paid. This method of accounting is considered more realistic and accurate as it gives a practical picture of the business. In this method, the revenue is matched with relevant expenses that generate the respective revenue.

Larger corporations, e-commerce stores with inventory, etc. are some of the common example of businesses that need to use the accrual method of accounting.

Advantages

Here we will discuss a few advantages of using the accrual accounting method in businesses:-

Fair financial report: Accrual accounting provides a fair picture of the business’s performance as it includes revenue and expenses, irrespective of cash inflows and outflows.
GAAP compliant: Unlike Cash accounting, accrual accounting is GAAP compliant. Businesses using this method of accounting are required to follow various accounting standards to remain GAAP-compliant.
Informed decision-making: This method considers all the relevant financial data, making it more suitable for businesses to make informed decisions.

Disadvantages

There are certain disadvantages to using the accrual method of accounting. For example,

Complex: To perform accrual accounting, advanced knowledge, and training in accounting principles are required. This makes it more complex and challenging to implement, especially for small ventures. Cash accounting is more suitable for such businesses.
Less focus on cash: This method of accounting may cause cash management issues as it focuses more on the long-term picture of financial performance, leading to overlooking immediate cash flow reality.

Cash vs accrual accounting: Key differences

Below listed is the basis of distinctions between the two primary methods of accounting –

Timing of transaction – In cash accounting, income and expenses are recorded only when cash is received or paid, whereas in accrual accounting they are recorded when they are earned or incurred, irrespective of the cash flow.
Suitability – Cash accounting is suitable for small enterprises, sole establishments, and freelancers, whereas the accrual method is ideal for larger businesses and companies with inventory.
Complexity – With the cash basis of accounting, financial statements are simpler and easier to manage, while accrual accounting requires a detailed understanding of accounting practices making it more complex for businesses.
Regulatory requirements – Cash accounting is generally non-compliant with GAAP or IFRS, while accrual accounting is required for publicly traded companies, and tax and reporting purposes.

Accrual Accounting vs. Cash Basis Accounting: Which is right for your business?

As a business, you need to consider various factors before selecting an appropriate method of accounting.

Size of the business –

Cash basis accounting offers simplicity and ease of tracking cash flow. Hence, it is beneficial for small businesses with simpler operations.
Larger businesses with inventory need accurate reporting, for which they should opt for accrual accounting.

Financial goals –

Entities that want to have a clear, long-term understanding of their financial performance must choose accrual accounting.
Businesses that prioritize cash flow management and simplicity must consider the cash basis of accounting.

Legal and tax requirements –

In some cases, businesses that meet specific size thresholds or handle inventory are legally required to use accrual accounting.

It is advisable to consult with a tax professional at Shuraa Tax to understand any legal obligations in your industry.

Conclusion

Thus, Accrual Accounting vs. Cash Basis Accounting is a common debate among businesses. While cash accounting is simple and easy to understand, accrual accounting provides a comprehensive view of the financial health of the businesses, which is needed for long-term growth and compliance. Therefore, businesses need to consider significant factors such as size, financial goals, and legal requirements before deciding on the appropriate method that best suits their business needs.

Come to Shuraa Tax and Accounting Services LLC and turn your financial vision into reality. Connect with their team at [email protected] and shape a brighter financial future for your company.