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Cash versus Accrual Basis Accounting

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Cash versus Accrual-Basis Accounting

There are two main methods of accounting; accrual and cash-basis accounting. The main

difference between the two methods is the adage timing is everything (Franklin et al., 2020).

Cash basis accounting represents the financial statements of a company’s business transactions

that occur when there is an inflow or outflow of cash in the business. on the other hand, accrual

basis accounting only recognizes revenue at the point it is earned and an expense when it is

incurred, irrespective of the actual time when money changes hands (Franklin et al., 2020). This

difference in timing influences the balance sheet and income statements of a company thus

affecting its tax liability. The main difference between the two accounting methods lies in the

timing of expenses and revenue; when they are incurred/earned and when they are paid/received.

In cash-basis accounting, all book-keeping activities follow the cash as the name implies.

In this method, a business records revenue when a customer makes payments and expenses when

the business pays its suppliers. The method, therefore, does not require the business to account

for sales made on credit until a customer pays (accrued revenue or accounts receivable). In a

similar fashion, the method does not require book-keeping for purchases made on credit from

vendors until the company pays them (accrued expenses or accounts payable) (Franklin et al.,

2020). In the accrual-basis accounting method, two main accounting principles are applicable;

the revenue recognition principle and the matching principle. Under the two principles, revenue

is recognizable when it is earned while expenses are reflected when they best match the revenues

they create. This method is uncoupled from the actual time when the money involved exchanged

hands (Franklin et al., 2020). Therefore, accrual-basis accounting smooths the impact of timing

and yields an accurate general picture of a company’s operations.

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Both cash and accrual-basis accounting methods have advantages and disadvantages that

limit their applications. While the cash-basis accounting method is suitable for small-scale

businesses that deal with cash, the accrual-basis accounting method is suitable for large

businesses that deal with credit paid at later dates (Khan, 2016). The cash-basis accounting

method is simple, easy, and cheap, and reflects the cash position of a business from its financial

statements. Additionally, under this method, a company does not need to pay taxes on cash it has

not collected. The major disadvantage of the cash-basis accounting method is the distortion of

financial results at any given time. The distortions complicate financial planning and forecasting

(Khan, 2016). Moreover, the method is not recognized by Generally Accepted Accounting

Principles (GAAP), thus making any resulting financial statements from this method considered

insufficient by lenders. Such financial statements are also restrained by publicly traded

companies.

The accrual-basis accounting method gives an accurate representation of the finances of a

company. Accrual-basis accounting enables businesses to easily keep track of credit transactions

(Khan, 2016). It uses accounts receivable system that indicates the full transaction details of

every customer. Similarly, it uses accounts payable system to indicate the transaction details

between a supplier or vendor and a company (Khan, 2016). Furthermore, the method is

recognized by GAAP. Among its disadvantages is the added book-keeping activities as it

involves monitoring accounts payable, accounts receivable, prepaid expenses, and other accrued

liabilities (Khan, 2016). The method may also be an obstacle to short-term cash flow problems.

As a new accountant at a salon that had previously been using the cash-basis accounting

method, I have to analyze the size of the business to determine if it is suitable for the accrual-
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basis method. A critical examination of the financial records of the salon shows significant

impending impacts of adopting the accrual-basis method. However, for the long-term benefits of

the salon, it is worth transitioning from cash-basis to accrual-basis accounting method. A closer

analysis of the salon’s financial statements indicates that the business is likely to experience both

positive and negative impacts of transitioning from cash to accrual-basis accounting method.

Positive Impacts

Transitioning from cash to accrual-basis accounting will enable the salon to post accurate

financial records at any given time. The accrual-basis method will also enable the salon to easily

keep track of the credit transactions. The method uses accounts receivable system that indicates

the full transaction details of every customer. Similarly, it uses accounts payable system to

indicate the transaction details between a supplier or vendor and a company. Furthermore, the

method is recognized by GAAP, thus allowing the salon to be a publicly-traded company.

Negative Impacts

The major negative impact of adopting the accrual-basis accounting method in the salon

is obscuring the short-term cash flow of the business. The accrual-basis method obscures short-

term cash flow problems in a business thus making it profitable on paper but risky in reality. It

may, therefore, deceive the owner that the business is making profits in the short term while

actually incurring losses. Other impacts come on the accountant themselves. As an accountant, I

have added the responsibility of monitoring accounts payable, accounts receivable, prepaid

expenses, and other accrued liabilities.

Recommendation
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Looking at the advantages and disadvantages of both cash and accrual-basis accounting

methods, I would recommend the salon transition from using cash to accrual-basis accounting

methods. The accrual-basis method guarantees the salon an accurate posting of financial records

and easier tracking of credit transactions as opposed to the cash-basis method.

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References

Franklin, M. Graybeal, P. & Cooper, D. (2020). Principles of accounting, volume 1: Financial

accounting. Open Stax Rice University. https://openstax.org/details/books/principles-

financial-accounting.

Khan, F. (2016). Comparative analysis between accrual basis and cash basis accounting in the

aspect of financial reporting (A study on some selective local firms in

Bangladesh). SSRN Electronic Journal. https://doi.org/10.2139/ssrn.2723802