You may have heard of two different types of accounting, namely cash basis accounting and accrual basis accounting. It’s important to know the differences between these two because they vary greatly, and having this kind of knowledge in your arsenal could significantly help you or your business. In this article, we’ll discuss the different types of accounting and their main differences. By the time you’re done, you should have a basic idea of what makes these two so different from one another, easily distinguishing one from the other.
Overview of Cash Basis Accounting
Let’s talk about cash basis accounting first. Basically, cash basis accounting only considers revenue when actual money or cash has been received. At the same time, expenses will only be recorded on statements when cash has been paid already. Most of the time, this kind of accounting method is typically used for either personal finances or by small companies who are still kickstarting their business off the ground.
Overview of Accrual Basis Accounting
On the other hand, accrual basis accounting is the complete opposite of cash basis accounting. For one thing, revenues are already considered and accounted for as soon as they are earned—even before the process of exchanging money takes place. With accrual basis accounting, they consider credit as revenue, so a business would still deliver a service or goods to a customer, trusting that they will pay for it in the future. In other words, even when cash isn’t being received or paid out just yet, all the revenues and expenses would still be recorded.
The Main Differences Between the Two
Now that you have a good idea about each accounting type, let’s discuss the key differences between the two. One of the major differences is that cash basis accounting is so simple, which makes it so advantageous to some businesses. As mentioned, everything revolves around actual money being paid or received. If you want to be able to track the cash flow of your company in a much easier way, this method is recommended as well.
That being said, the cash basis of accounting isn’t perfect, and there are some things that you have to look out for, too. For instance, the downside to this method is that there’s a chance it might end up overstating your company’s health due to how cash-rich it is. However, if you dig deeper, you might end up discovering that your company has a lot of accounts payables to deal with that far surpass the amount of money in your current revenue stream. As you can see, that’s a big problem and is a situation that no company would ever want to experience. In the case of investors, they may think that the company they’re investing in is making a profit, but in actuality, they’re actually losing money.
On the other hand, the accrual basis of accounting is capable of painting a more accurate picture of your company’s financial health, simply because it includes the accounts receivables and payables. As soon as any revenue is earned or any expense is made, this method of accounting immediately records them. Of course, the accrual basis also has a disadvantage. Specifically, it doesn’t record your company’s cash flow.
As you can see, these two types of accounting are completely different from one another and it’s important that you’re able to distinguish them from each other and know when and when not to use them.