Before recording transactions, a business must decide whether its books of accounts will be based on an accrual basis or a cash basis. Accrual accounting is defined as the method of accounting in which expenses are recorded in accounting books when they are incurred and income is reported when it is earned, and not when cash is received (Ward, 2013). In a nutshell, the accrual method records expenses and revenue when they occur. Conversely, transactions in cash accounting enter books of accounts when payment is made. That is, revenue enters books of accounts when customers make payments, and expenses are recorded in books of accounts when the company makes payments (Epstein, 2012).
The main difference between accrual and cash accounting is the fact stated in their definitions. That is, the accrual method records expenses and revenue in accounting books regardless of whether cash is paid out or payments are received, while cash accounting records transactions after cash are paid out or cash receipt is confirmed. Cash payment or receipt can take the form of electronic transfer, cash, credit card, check, and other various methods of making payments.
The cash method cannot be used in businesses with a high number of credit transactions. This is because the cash method lacks a provision for recording money due from customers. The same also applies to purchases. In the cash method, a business records that it has made purchases after it pays for the goods or services. If credit purchases are made, the cash method will not record the transaction until it is paid for. This means that an important transaction can miss from books of accounts (Epstein, 2012).
As stated above, the accrual method records transactions even if cash is not paid out or received. This implies that the accrual method records all transactions. Revenues made on credit appear in the Accounts Receivable area of the books of accounts until cash is received. In the same way, goods bought on credit are entered in the Accounts Payable section of books of accounts until cash is paid out. The accrual method, therefore, allows a company to generate vendor payables reports as well as reports on customer receivables.
The latter can be sent to debtors with all the details of the amounts due. In the accrual method, therefore, a company’s balance sheet shows amounts to be received from customers, which are an asset. In the same way, the balance sheet shows the amounts to be paid to suppliers as a liability (Snyder, 2008). Just like its cash counterpart, the accrual accounting method has disadvantages. One of its drawbacks is that while it records all revenue and expenses, it is poor in tracking cash. Thus a company’s income statement may be impressive even when the company does not have cash.
One of the main reasons why accrual accounting is preferred over cash accounting is the fact that an accrual accounting system is also capable of generating cash basis reports. “This is the best of both worlds, matching revenues to expenses and giving information on accounts receivables and accounts payables while still being able to generate reports that approximate what happened on a cash basis” (Snyder, 2008, p. 1). It is however important to note that accrual accounting is poorer than cash accounting in tracking cash. The accrual method is vital for recording transactions in businesses that have a considerably high number of credit transactions.
Reference List
Epstein, L. (2012). Deciding between Cash-Basis and Accrual Accounting. Web.
Snyder, S. (2008). Understanding cash and accrual basis accounting. Web.
Ward, S. (2013). Accrual basis accounting. Web.