Accrual accounting and cash-basis accounting are the two most commonly used accounting methods by businesses. These accounting methods comprise certain rules and procedures that companies follow when reporting their finances.
The primary difference between the two is the timing when revenues (accounts receivables) and expenses (accounts payables) are recognized and recorded. Moreover, some are free to choose whether to utilize accrual or cash-basis accounting, while other businesses are mandated to use an accrual accounting method.
Many other factors set these methods apart, and entrepreneurs need to know these differences to ensure they use the right one when managing their finances.
What is Cash-Basis Accounting?
In cash-basis accounting, revenues and expenses are recorded only when the cash changes hands, regardless of when they were invoiced. For example, if you sell an item today but the customer paid a month later, then the revenue will only be recorded once you receive the payment.
Cash-basis accounting offers a key advantage – its simplicity. It also enables easier tracking of cash flow in real-time. However, its disadvantage is that it might provide an inaccurate portrait of the business’s health. A company might record a cash-rich revenue but might have a large sum of expenses that are yet to be paid, exceeding their income stream.
Additionally, this accounting method is typically used for personal finances. Some small businesses also use it, but others might be required to utilize the accrual accounting method instead.
In Canada, farmers, fishers, and self-employed commission agents can choose either cash-basis accounting or accrual accounting. Nevertheless, they cannot use a combination of both.
What is Accrual Accounting?
In the accrual accounting method, accounts receivables and accounts payables are recorded when the transaction occurred, even though cash is yet to change hands at a later time. For example, if you made a sale today, it is immediately recorded even if you receive the payment days or weeks later.
This accounting method portrays a more accurate picture of the business’s health, especially in the long term. It also allows enterprises to analyze trends and manage finances more properly.
Furthermore, when companies use accrual accounting, they must implement proper cash flow management and perform a cash flow analysis to monitor the money coming in and flowing out. Accrual accounting may also be more complex since it covers other particulars like unearned revenue and prepaid costs.
Most businesses and professionals in Canada and the US are required by law to use this accounting method.
Choosing the Right Accounting Method for Your Business
Determining which accounting system is most suitable for your business is crucial in keeping finances organized and adhering to legal requirements. It also plays a vital role when it comes to investment decisions.
Whether you use accrual or cash-basis accounting, it is equally important to entrust your finances to well-experienced accountants to ensure accuracy in the process. If you do not have the budget for an internal team, an ideal and cost-effective alternative is to outsource online accounting and bookkeeping services from reputable providers.
Similarly, using business accounting software simplifies tasks and reduces errors that often occur with manual procedures.
Once you have chosen which accounting method to go with, you must follow it through consistently. Should you wish to change accounting methods, you must first have it approved by the governing agency in the country.
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