Small and medium scale enterprises have to endure a tough time while selecting the most appropriate accounting method for your organisation. The choice boils down to two options- which one to select out of cash vs accrual accounting. If you are a business owner facing this same conundrum, then this article is for you.
Different Basis of Accounting for SMBs: An Overview
When it comes to different basis of accounting, there are three main types. They are:
- Cash Basis Accounting
In this accounting method, any inflow and outflow of income or amount is recognised only when it has changed hands.
- Accrual Income Accounting
Businesses making use of the accrual concept of accounting consider an invoice as an income source as soon as it is raised. In a similar fashion, a bill is considered in outstanding payments even if it is not to be cleared for sometime.
- Hybrid Accounting
A venture employing both cash basis and accrual basis of accounting is said to have a hybrid accounting method. They use cash basis for paying their taxes while they use the method of accrual of their expenses for loan applications.
What is Cash Accounting?
In cash basis of accounting, any expense or income is entered into cash book records only when they have been finally processed. This means that any entry made under the accounts receivable and accounts payable section is not taken into consideration.
SMBs make use of this credit to cash accounting as it is simple and easy to maintain. Payments that have been received or bills that have been paid are easier to track on the basis of your bank statement. Cash account is useful for SMBs to gain a knowledge of the exact amount of resources available for utilisation.
Cash Basis Accounting Examples
Let us help you understand the nitty gritty of cash basis accounting with the help of a practical example.
Let’s assume that a certain company sells ₹30,000 worth goods to a customer in the month of May. But the customer clears the invoice in the month of June. If the company follows a cash basis accounting method, then this income would be recorded as part of its financial books in June only.
Recording Bill Payments
Now consider the same company paying off a supplier for purchases worth ₹9000 made in the month of February. Although the purchases were made in February, payment was made in April. If the company makes use of cash basis of accounting, this expense will be recorded in the month of April, when the final bill is cleared.
Advantages & Disadvantages of Cash Basis Accounting
Advantages of cash book in accounting
- In this method, transactions are not recorded until the payment or bill is cleared. This means that your business profit won’t be liable for taxation for that period.
- Cash basis accounting is preferred for keeping a tab on the cash flow of your company as you only need to track transaction history and not receivables or payables.
- Cash accounting is comparatively easier to maintain.
Disadvantages of cash accounting
- This method lacks accuracy. Although transactions would be recorded only when the bill is paid, this does not mean that you don’t have to allocate funds for bill payment. On the contrary, you might count funds meant for bill payments as part of your profits erroneously.
- Cash accounting is not the perfect method for deciding the financial health of a company. It might reflect that the company is in a profit position based on pending invoices while it may run into loss in the long run.
Suggested Read: 12 Best Free Accounting Software: A Comprehensive Guide
What is Accrual Accounting?
Accrual concept in accounting refers to the practise of recording a transaction as soon as an invoice is generated or received. This is done even if the amount has not been credited or debited from the company’s account.
The main reason why SMBs should be going for accrued revenue in accounting is that it helps them manage long term financial goals. They need not wait for funds to be debited or credited to update their books.
Accrual Basis of Accounting Examples
It's a common sight for beginners to get confused while understanding the meaning of accrued in accounting. Let us help you out with the help of an easy to understand example.
Imagine a medium scale enterprise that sold ₹50,000 worth products to a customer in December 2019 but received the payment in January 2020. If the company makes use of an accrual basis of accounting, then this transaction would be recorded in the month of December itself. That is in the month when products were sold.
Recording Bill Payments
The same company owes ₹80,000 to a supplier and it raises the invoice in August. But the final payment is made in the month of September. Then a debit of ₹80,000 will reflect in the books in the month of August itself even if the invoice was cleared in the month of September.
Advantages & Disadvantages of the Accrual Concept of Accounting
Advantages of Accrual Income Calculation
- The main advantage of accrual concept is that companies can get a hold of their financial situation for the long term.
- Accrual concept is based on accuracy. Since the company already segregates income and bill payment before they are processed, the possibility of counting funds meant for outstanding payments as the part of company profits can be eliminated.
- It is a suitable accounting method for organisations whose operations are inventory intensive.
Disadvantages of Accrual Registration of Expenses
- In accrual basis of accounting, you have to pay tax on income even before the cash inflow. In case the customer forfeits your payment, you put in claim for getting the tax back only when you file your next income tax return.
- Accrual accounting may help you set long term financial goals in order but it does not take into account any short term cash shortage your business might be facing.
- It can be complicated to handle as you have to include revenue yet to be earned and advance expenses.
Cash Vs Accrual Accounting: Key Differences Between Cash Basis and Accrual Basis of Accounting
We have looked at the basic features, advantages and disadvantages of both cash vs accrual accounting. It is time to compare both to understand which one would be more suitable for your organization.
|Accrual basis of accounting||Cash basis of accounting|
|Transactions are recorded after a purchase has been made or an expense encountered even if the funds have not been transferred in real life.||Transactions are recorded only when funds have been credited or debited from the company's account.|
|Suitable for setting long term financial goals for the company.||Suitable for overlooking day-to-day business deals made by the company.|
|Tax has to be paid on income you are yet to receive from the customer.||No tax has to be paid until the income is credited to your company’s account.|
|Clear distinction between incoming and outgoing funds prevents the consideration of funds meant for bill payments as part of profit.||Possibility that funds allocated for bill payment may be counted as profit. Bills are not paid immediately under cash basis of accounting.|
Cash Basis or Accrual Basis of Accounting for SMBs
Now to answer the most sought-after question, the one whose answer you have been speculating throughout this article. Which of these accounting techniques you can prefer for your business?
- If your business is inventory-intensive, we suggest that you opt for accrual basis of accounting. But if your business involves the minimum use of inventory, your accountant might suggest you opt for cash basis of accounting.
- Accrual method can be utilized to conduct a month-by-month profit analysis of your company. Although cash accounting helps you with tax management, the lack of accuracy nullifies the usability.
- Some critics might complain that accrual accounting involves a lot of tedious work. But with our modern-day accounting software, a major portion of these redundant tasks can be automated, thus increasing the efficiency of your accounting team. Moreover, the best accounting solutions recognize the dynamic needs of your business. Hence, they allow you the option to switch from accrual basis to cash basis and vice-versa.
So here is our 2 cents on the ever going debate on cash Vs accrual accounting. Remember both have their own merits and demerits. Cash accounting can help you save tax but is not useful for financial strategies. On the other hand, accrual accounting presents an accurate picture of your company profits but can be complicated to manage. SMBs can also opt for hybrid accounting, in case they want the best of both worlds, with the help of accounting software.
You can also check, List of Top 30 Accounting Software Solution for SMEs in India