Do you know how your books and records are accounted for?

Many bookkeepers will use a simple cash-based accounting system that ensures that transactions are recorded when cash outflows or inflows occur.

Yet, generally accepted accounting principles do not include cash-based recording. Accrual accounting is what’s required by financial statement users as businesses grow.

Here’s the basics:

• Cash accounting is more straight-forward.
• CPAs (designated professionals – Chartered Professional Accountants) would question if it is even considered accounting! (They’d also be shocked at how frequently it’s used.)
• In reality, cash accounting is suitable for owner-operated small and medium businesses. It makes a lot of sense in the early days, especially.
• Most people doing the accounting who were not CPAs, in the early days, do not know anything differently.
• However, companies of a specific size or reporting to investors, bankers, or other financial statement users cannot use cash-based accounting as it is considered insufficient and prohibited for compliance.
• It’s also limiting to operational and strategic decisions within the organization.
• Accrual accounting, on the other hand, follows generally accepted accounting principles and is expected by financial statement users.
• Accrual accounting is recommended for businesses that plan to grow and scale.
• Eventually, if successful, all companies must use accrual accounting.

Let’s dive deeper:

Cash-Based Accounting

• Cash-based accounting is simple and low-cost. It is a form of bookkeeping that reflects the cash status of a business and is reflective of cash-based business models.

Accrual Accounting

• Financial statement users require accrual accounting. Chances are, if your financials are requested by financial statement users such as banks and investors, they will need accrual accounting.
• Accrual accounting provides a more accurate picture of business operations and makes forecasting and planning easier. It is reflective of credit/cash business models.

Differences between Cash and Accrual Accounting

There are several key differences between cash and accrual accounting. A cash basis is easier to use, while accrual accounting requires estimates, judgments, and policies.

Cash-basis records cash, so the cash flow statement is not relevant. Instead, the profit and loss statement is relied on and often clearly shows the business’s cash status.

Accrual accounting, conversely, records revenue earned or cash inflow served and liabilities incurred or cash outflow owed. It presents a more accurate representation of the finances of a business.

Under a cash basis, liabilities are not recorded until paid.

Transactions are not recorded between the business and its vendors, suppliers, or customers unless there is a cash inflow or outflow. So, this means expenses and revenue are only recorded when the cash is paid.

Under accrual accounting, in simple terms, expenses are reflected in the period that best matches the revenue they helped create.

On a cash basis, services and products delivered are not recorded until paid. Revenue is only recorded when the cash is received.

Under accrual accounting, revenue is recognized when earned. The recording of revenue aligns with when the rewards and risks of ownership are transferred from the seller to the buyer.

Cash accounting can add risk to the collection when cash is not received during the sale. It can also add risk to liability or obligations when money is obtained before the service or product.

Accrual accounting records revenue when the rewards and risks are transferred.

The cash basis is straightforward, with minimal judgment or estimates, allowing for less skilled book-keepers and fewer hours required.

Accrual accounting requires more time for closing books, reconciling, and making management decisions on estimates, judgments, and policies. The time and skillset will cost more.

Most lenders or investors expect generally accepted accounting principles and assurance, which means businesses would have to move to accrual accounting.

Initial public offerings require generally accepted accounting principles.

Most other financial statement users, including buyers, will require generally accepted accounting principles and assurance.

As businesses become more complex or extensive, the transparency of liabilities, regardless of the amounts paid, is critical for managing costs and risks and optimizing profits and margins. Further, a clear understanding of sales, including before collection, supports growth, ambitions, margins, and profits. Business leaders also rely on an updated balance sheet, cash-flow statement, forecasting, and reporting of operational key performance indicators.

In conclusion, cash accounting is more straightforward and suitable for small and medium businesses. In contrast, accrual accounting is required for most financial statement users and is recommended for companies that plan to grow and scale.

So the question is – what do you use? And, when are you levelling up to accrual accounting?

Interested in learning more?

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