There are typically two methods companies use to account for transactions, known as the cash basis and the accrual basis methods of accounting. The main difference between these methods of accounting is when revenue and expenses are recognized by a company.
A company that uses the cash basis of accounting recognizes revenue as soon as cash is received. Expenses related to that revenue are recognized as soon as cash is paid out for the expense. Because of this, when a company uses the cash basis approach, there is no need for an accounts receivable and accounts payable team. One of the main reasons a company would choose to use the cash basis method of accounting is because of its simplicity and the ability to have a better understanding of how much cash the company has on hand at a given point in time.
A company that uses the accrual basis of accounting recognizes revenue when it is earned, regardless of when cash is actually received. Expenses related to that revenue are recognized when the service is performed or the product is delivered. The accrual basis of accounting is more commonly used than cash basis is used. One of the main reasons a company uses the accrual basis of accounting is to get a more accurate indication of a company’s income and expenses during a period of time, thus giving a better overall long-term depiction of a their financial situation. Most large-sized companies are required to use the accrual basis method of accounting.
The best way to explain the difference between cash basis and accrual basis accounting is with an example. A company sells a product for $100 on December 28, 2016. The company pays for and manufactures the product on December 29, 2016, and the customer receives the product on December 30, 2016. The customer pays for this product on January 5, 2017 in its full amount.
A cash basis company would recognize the revenue for this product in 2017 because that’s when they received the cash for the product. However, they would recognize the expense for the product in 2016 because that is when they paid cash to manufacture it.
An accrual basis company would recognize the revenue for this product in 2016 because that’s when the product was manufactured and delivered to the customer, even though the cash for this product was not received until 2017. The company would also recognize the expense in 2016 for the same reason; the product was manufactured in 2016.
Companies that are trying to decide whether to use the cash basis or accrual basis method of accounting need to determine how and when they want to recognize revenue and expenses. The company needs to decide what’s more important: having a better understanding of how much cash they have on hand at a given point in time, or have a better understanding of the long-term financial health of the business.